Morningstar Guide to ETF Investing
Exchange-traded funds are an easy and affordable way to gain exposure to a range of local and international asset classes and thereby diversify your portfolio, but like all investments, there are risks you should be aware of.
Mentioned: SPDR® S&P/ASX 200 ETF (STW)
Before we get into the dirty details of exchange traded funds, let’s take a step back. Why do you want to invest in them? If you’re expecting a how-to on trading ETFs, throw this guide into the bin. But before you do, let me explain why it’s a bad idea. What is great about ETFs is how easy it is to buy and sell them. The downside of the ease in trading ETFs is that it can help encourage two of the main ways that investors get in trouble:
- Problem #1: Chasing returns. If you’ve ever talked with mates about the stock market, you’ve probably felt the urge to invest in a new hot stock or sector. The problem is this: so has everyone else.
- Problem #2: Exiting the market during downturns. When the markets get jumpy, people ask themselves, “Is the market going to fall more, and should I get out?” Unfortunately, it’s impossible to tell whether a drop in the markets will continue, or whether it will rapidly turn around. In the extreme, Morningstar research shows that if investors pulled out of the market and missed the 10 best upswing days from 1992–2012, they’d have lost 45% of their returns.
The highest and best use of ETFs is to obtain passive exposure to markets and reap the rewards for bearing risk. It’s about low cost, transparency, and getting your fair share of capitalism’s growth. Don’t throw that all that away on a vague, ill-founded belief in your ability to beggar thy neighbour.
The full guide can be found on Morningstar Investor and dives deeper into initial considerations for ETFs by investors.
The ETF structure
Exchange-traded funds, a motley bunch, share three qualities: they’re pooled investment vehicles, their shares trade on stock exchanges, and they have a daily share creation and redemption mechanism. An ETF can be thought of as a managed fund whose shares happen to trade on stock exchanges.
The biggest ETFs are passive investments, which merely try to replicate the behaviour of a market or market segment. The biggest ETF in Australia, SPDR® S&P/ASX 200 ETF (ASX: STW), tracks the ASX 200 index. In recent years, quasi active index strategies as well as full-blown active ETFs have gained traction, but they’re still small.
The ETF bears a strong resemblance to the Listed Investment Company, or LIC, which raises a fixed amount of capital in an initial public offering. LICs have a net asset value, or “fair value”: what the LIC could disburse to its investors if it liquidated all its assets and paid off all its liabilities. Because LIC shares trade on exchanges, their prices often deviate from their Net Asset Values (NAV). LICs sometimes undertake actions to close the gap between NAV and market price, but such actions must be initiated by the board of directors. ETFs, on the other hand, create and redeem shares at NAV at the end of each trading day, just like managed funds. The daily share creation/redemption mechanism makes ETFs unique.
The full guide on Morningstar Investor dives deeper into how ETFs are structured.
How to trade ETFs
Like any stock, an exchange-traded fund has two prices: a bid and an ask (or buy/ell spread), the prices at which you can sell and buy shares, respectively. The difference between the two is called the bid-ask spread, or spread. It is the transaction cost of buying then immediately selling a security (a round-trip trade). The spread compensates market-makers for the costs and risks they bear for keeping shares on hand.
5 tips for trading ETFs
Investors can overcome these trading issues if they exercise caution when using passive ETFs in their broader portfolios. Find them in the full guide on Morningstar Investor.
How much does that ETF really cost?
Fees deserve a good amount of thought. Most investors focus on the prospectus net expense ratio, the annual percentage fee on assets that a fund is expected to pay over the coming year. It’s a good guide. Over the long run, well-constructed ETFs lag their benchmarks at an annualized rate close to their expense ratio. This is especially true for ETFs that track liquid markets, like U.S. stocks and Treasuries. However, the expense ratio is an incomplete measure of total cost. It’s a floor, not a ceiling.
While there are several types of hidden costs, the most insidious and biggest of them is undoubtedly market impact. It can be many multiples of a fund’s stated expense ratio. Market impact is the adverse price change that arises from a trade. There is no way to detect market impact costs by comparing a fund’s performance with its benchmark.
Types of ETFs
Since exchange-traded-funds (ETFs) began trading in Australia 20 years ago, there has been a proliferation of different types.
Today, more than 200 exchange-traded products trade on the Australian Securities Exchange, some tracking broad market indexes, while others offer exposure to popular trends such as cybersecurity.
This plethora of competing products is making it harder for investors to make informed decisions for not all ETFs are created equal.
The following section guides you through the different types of ETFs so you can select the right funds for your portfolio, with teh full guide providing examples.
ETFs that track market indices are called passive ETFs.
Active ETFs are run by a manager or a management team that attempts to outperform their designated index.
Smart Beta ETFs
Asset class ETFs
Stock ETFs, Bond ETFs, Property ETFs
Stock ETFs—also known as equity or share ETFs—are the most common type of ETF you'll come across. Stock ETFs track the performance of a specific market index.
You can also buy ETFs that will give you exposure to other asset classes such as bonds and property. Like buying a traditional bond, a bond ETF will still give you interest/coupon payments.
Most currency ETFs track the performance of a currency such as the US dollar or euro. You'll make money if the Australian dollar slumps, or if the other currency soars. But in the reverse situation, you'll lose money.
Index ETFs traditionally offer exposure to a single asset class—e.g. large-cap Australian equities or Emerging Market Shares.
Sector ETFs Consumer staples, technology:
Sector ETFs allow investors to buy into companies in a specific sector.
These funds seek to capitalise on the growth of popular trends such as cybersecurity or the spending habits of millennials.
The ethical fund industry is expanding to accommodate the growing number of investors seeking to put their money in companies they feel do the right thing.
Find further details and examples of these different types of ETFs in the full guide on Morningstar Investor.
How Morningstar rates ETFs
Too many investors focus on short-term performance when evaluating funds and ETFs. An overemphasis on short-term performance can cause investors to make poorly timed buy and sell decisions. The reason for this is simple. By their very nature, returns are backward-facing. Simply looking at the past performance doesn’t tell you why it occurred, and it certainly can’t predict if the same returns will continue into the future.
The Morningstar Analyst Rating is a forward-looking analysis of a fund or ETF’s likelihood to outperform. The Analyst Rating is based on the analyst's conviction in the fund or ETF's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund or ETF receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund or ETF and expect it to outperform over a full market cycle of at least five years. To determine this rating our manager research analysts evaluate funds and ETFs based on three key pillars– Process, People and Parent– which we believe indicate a likelihood for outperformance the long-term on a risk-adjusted basis. Each of the following pillars will receive a rating:
- Process: What is the fund's strategy and does management have a competitive advantage enabling it to execute the process well and consistently over time?
- People: What is Morningstar's assessment of the manager's talent, tenure, and resources?
- Parent: What priorities prevail at the firm? Stewardship or salesmanship?
Each ETF that we cover will receive one of the following ratings:
- Gold: Best-of-breed ETF that distinguishes itself across the five pillars and has garnered the analysts' highest level of conviction.
- Silver: ETF with advantages that outweigh the disadvantages across the five pillars and with sufficient level of analyst conviction to warrant a positive rating.
- Bronze: ETF with notable advantages across several, but perhaps not all, of the five pillars—strengths that give the analysts a high level of conviction.
- Neutral: ETF that is unlikely to deliver standout returns but also unlikely to significantly underperform, according to the analysts.
- Negative: ETF that has at least one flaw likely to significantly hamper future performance and that is considered by analysts an inferior offering to its peers.
How we can help you achieve your financial goals
Morningstar’s core mission is to help individual investors make better financial decisions. The following section in the complete Guide to ETF Investing outlines how Morningstar helps investors select ETFs to achieve their financial goals.
Discover new investments
- pre-defined ETF screens that show our Gold, Silver and Bronze rated ETFs across a number of asset classes;
- investment filters that allow users to select criteria to search our database of over 200 Australian ETFs.