Australia’s exchange-traded fund sector continues to swell, with the larger funds boasting billions of dollars in assets. But when it comes to choosing an ETF, does bigger mean better?

After a record year for inflows in 2020, ETFs have hit the ground running in 2021, with high inflows pushing the sector to a new all-time high of $96 billion in January. Over the past 12 months, the sector has grown by 47 per cent, adding more than $30 billion in assets, according to BetaShares.

By sector, the top inflows for January were international equities (around $867 million) and Australian equities ($315 million), followed by fixed income ($239 million). Outflows were limited, with only specific outflows such as for resources exposures linked to crude oil following strong price gains, BetaShares reported.

Among the 256 exchange-traded products (ETPs) listed on the Australian stock exchange or Chi-X, the larger funds have continued to attract investment. Vanguard Australian Shares Index ETF (ASX:VAS) topped the list with $7.16 billion in net assets as of December 2020, followed by the SPDR S&P ASX/200 Fund (ASX:STW) with $4.2 billion and the iShares Core S&P/ASX200 ETF (ASX:IOZ) with $3.6 billion.

At the smaller end of the market however are ETPs such as the BetaShares Euro ETF (ASX:EEU), with around $3 million in funds under management, the BetaShares Global Government Bond 20+ Year ETF – Currency Hedged (ASX:GGOV) with nearly $4 million and the eInvest Future Impact Small Caps Fund (ASX:IMPQ) with around $5 million.

Large vs small

Larger funds benefit from economies of scale, since the smaller the fund, the higher the proportion of administrative costs. Larger funds also have the advantage of greater revenue streams, giving them more resources and allowing them to invest in improving processes, while also attracting further inflows from higher marketing expenditures.

“At the outset, it is imperative for an ETF to attain a certain size to become financially viable. Once an ETF reaches this size, the provider starts reaping larger profits and the longevity of the fund is reinforced,” said Zunjar Sanzgiri, senior analyst, manager research at Morningstar Australia.

“Additionally, larger ETFs have much more flexibility with respect to garner and retain AUM [assets under management] by reducing costs, particularly in a competitive market. Larger ETFs generally have superior tracking errors and higher trading volumes, which leads to better price discovery and liquidity. The higher trading volumes also result in improved liquidity, enabling investors to buy and sell them more efficiently.”

However, size does not equal outperformance in terms of investor returns.

For example, one of the best recent performers is the ETFS Physical Palladium (ASX:ETPMPD), with net assets of $8.8 million, which has posted a 32 per cent return on a three-year basis. Other notable funds include the $282 million ETFS Morningstar Global Technology ETF (ASX:TECH), which has posted a three-year return of 27 per cent.

At the larger end, the $1.6 billion BetaShares Nasdaq 100 ETF (ASX:NDQ) has shown a three-year return of nearly 26 per cent, according to Morningstar data as of 13 February.

“Considering that the ETFs are mostly a passively-managed product with a majority of them following similar indices, there is no material difference between the performance of larger ETFs versus the smaller ones,” Sanzgiri said.

“However, the narrow bid-ask spread, better tracking and higher liquidity leads to lower volatility for the larger products.”

The $1.6bn BetaShares Nasdaq 100 ETF (ASX:NDQ) has shown a three-year return of nearly 26pc, according to Morningstar data as of 13 February

The analyst points to the role of smaller funds in sparking innovation in the sector.

“In traditional categories such as broad diversified equities, the larger players have a strong foothold, enabling them to offer extremely cost-effective options and thereby accumulating a significant portion of industry flows,” Sanzgiri said.

“Having said that, smaller funds certainly have a role to play, not only in terms of keeping the big players on their toes, but also by offering innovative options focusing on under-tapped market niches and unique thematic options, such as strategic beta or sustainable investing.”

Follow the money?

Equities have been the flavour of the month for investors lately, as Australian and international stocks continue to benefit from central banks’ easy money policies.

Asked whether ETP investors should “follow the money” and invest in sectors attracting the larger fund inflows, the Morningstar analyst expressed caution.

“Inflows are certainly a signal of investor sentiment. The sudden movement out and back into equities during and after the February-March corrections of 2020, and the sustained inflows into funds focusing on sustainability, are two distinct examples of investor behaviours which are noticeable through their inflows,” Sanzgiri said.

“However, it may not be case the other way around. Investing on the basis of flow patterns is not recommended. It is more important for an investor to first determine the appropriate allocations for their respective portfolios.

“It may also be noted that, at times, major inflows and outflows are driven by the movements of large institutional investors, and not the overall market sentiment. The goal of long-term investing should not be clouded by momentary changes in flow direction.”

With Australia’s ETF sector continuing to attract investment in 2021, the outlook appears positive for further growth ahead, the analyst said.

“Despite an unforgettably tumultuous year, funds under management for ETFs soared in 2020 and there is no reason to believe that the growth will slow down for some time to come,” Sanzgiri said.

“The appeal of low-cost investment options continues to pull investors towards passive and strategic-beta ETFs. In recent times, sustainability focused funds have been attracting greater attention from investors, as seen from the new launches as well as the fresh inflows.”

Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.

See also Morningstar Guide to International Investing.