Friday fundamentals webinar: Deep dive into ETFs

-- | 15/04/2019

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Emma Rapaport: ETFs are a big new feature of the Australian investing landscape. They are cheap, they're easy to get and some people even say they're great diversifier for everyone's portfolios. We're going to be talking today with Morningstar's resident ETF Expert Alexander Prineas.

Alex thanks for joining us.

Alexander Prineas: Thanks Emma.

Emma Rapaport: If anyone has any questions, we're dying to know them. So send them in, put them in the comments and Alex will try and answer them later. So Alex first question ETFs another acronym, can you explain to – what exactly ETFs are and how they work.

Alexander Prineas: Sure, yes. So the acronym is exchange traded funds. As the acronym or the name suggests they are a fund that trades on an exchange. So what does that mean, they have some of the attributes of managed funds or super funds in that you get a diversified portfolio in one instrument. You're investing alongside other investors and you have a share of the assets of the fund. But then similarly to buying or selling a share or a stock you are doing that on the stock exchange and you can trade any time that the exchange is open. So in Australia that's generally 10:00 AM to 4:00 PM.

Emma Rapaport: Great. And what are some of the things about ETFs that you love and some of the things that are disadvantages for investors.

Alexander Prineas: Sure. So it depends on the ETF a little bit. Morningstar's database has about 200 ETFs and the variety is huge in terms of the cost, scale, the investment strategy. So when I say sort of pros and cons of ETFs in general it's impossible to completely generalize. But I think we can make some generalizations. So as you said ETFs are mostly low cost, that the cheapest ones are incredibly low cost compared to active funds as measured by their management fees. And they're also low cost in terms of brokerage versus putting together a portfolio of shares. Because if you say you wanted a portfolio of 100 stocks that's going to cost you thousands of dollars in brokerage. But with an ETF you can do that with one trade. They are also as I said very diversified. They are tax efficient. Generally the portfolio turnover is low so that's minimizing or delaying your capital gains tax and transaction costs within the ETF. And they're also transparent you can generally see what you own in the ETF. So there's plenty of advantages of ETFs.

Emma Rapaport: And one of the great advantages is that they give you access to all these different asset classes that you wouldn't have gotten before.

Alexander Prineas: Yeah, that's right. So you can invest offshore in global equities very easily as opposed to that can be quite difficult or costly and involve a bit of paper work doing that by other methods. Similarly with things like bonds if you wanted to buy bonds directly you might have to outlay hundreds of thousands of dollars just to make the minimum investment requirements. But within ETF you can do that with you know a few thousand dollars and it's cost effective.

Emma Rapaport: I know there are some things that investors should watch out for with ETFs.

Alexander Prineas: Yeah, I mean first of all as I said not all ETFs have those advantages. There is a huge variety out there. And you do need to sort of do the homework before you invest or else you know there could be unexpected risks there. And another potential disadvantage is around how easy they are to trade. So, you could be your own worst enemy if you you're tending to trade too match, rack up brokerage and bid-ask spreads and not necessarily sticking to your investment strategy.

Emma Rapaport: So (if only) you really take a long term approach or they might stop you from doing that.

Alexander Prineas: You certainly can take a long term approach and that's the approach that we sort of look at ETFs through. But yeah there is that danger there that with – how easy they are to trade and how efficient they are to trade that you might be tempted to do that more often than might be appropriate.

Emma Rapaport: With almost 200 on the – trending on the Australian stock exchange I'm sure everyone out there is wondering how you go about evaluating these ETFs. And as a researcher what are some of the things that Morningstar looks for when they are rating ETFs and what should investors look out for.

Alexander Prineas: Sure, so the first thing I would say is that we – Morningstar does not use a model where fund managers pay to get rated. Essentially ultimately our subscribers and customers buy Morningstar's research and that's what allows us to do independent research. Looking at it from the investor's viewpoint and we tend to as I said look at it from a long term investors viewpoint. So how do we evaluate ETFs or any funds. We use a 5 pillar approach. So we look at 5 different pillars. The people that run it, the parent company, the performance of the vehicle, its price and the investment process. So for ETFs probably the 2 that we place the most emphasis on is the price and the investment process.

Emma Rapaport: Maybe we can explore those ideas with one of the questions that we received from Ryan, he asked us IVV or VTS they're 2 different exchange traded funds that are looking at similar markets, how would you go about evaluating difference between those and I guess picking one or the other.

Alexander Prineas: So those are two U.S. equity ETFs and they are both Gold rated by Morningstar. They both give you a very diversified portfolio of U.S. stocks. So generally we've observed in the U.S. the average active manager has struggled to beat the mainstream stock market benchmark. So we're already very favorably disposed towards investing via kind of passive index funds in the U.S. So that sort of provides them with a pretty good tailwind. Then they're also incredibly low cost so they both charge 0.04% which is you know you go much below that and you are almost getting towards being free.

Emma Rapaport: It's negligible.

Alexander Prineas: Yeah exactly. So they're both Gold rated. We kind of hold both of them in very high regard. If I had to sort of pick differences between the 2. So the iShares product tracks the S&P 500 which gives you 500 of America's largest stocks. So it is well diversified one maybe slight drawback relative to the Vanguard product. Vanguard VTS is that – the Vanguard product is even more diversified. So it holds 3,500 companies. So it's taking you a little bit down – little bit further down the market cap the size spectrum. But then a slight drawback on the Vanguard product is that it's a cross listing. It's actually a U.S. listed ETF, listed in New York. It is cross listed into Australia for Australians to access. But that does come with a few little extra paperwork issues and potentially some some complications around U.S. estate tax. So the Vanguard product is more diversified maybe a little bit more complex. But there's not much between the 2. They're both very high quality products for long term investors.

Emma Rapaport: If we look at some of the product the ETFs that you're not so I guess crash hot on I understand that Morningstar prefers active management when it comes to small caps. Can you explain why that is?

Alexander Prineas: Sure. So in Australian small caps we've generally found that nearly all active managers have been able to beat the index over the long run. And there's different arguments for why that may be. We think it's largely because of the number of speculative companies. You know you've got speculative mining stocks or speculative technology stocks that maybe aren't making a profit. And if you own the index, if those stocks are in the index then you own those stocks. Whereas active managers don't have to own them and they've generally been able to beat the benchmark. So for that reason we have rated ETFs that track the S&P/ASX Small Ord and some of the other similar small cap benchmarks where we rate them Neutral. They do their job, but we prefer some active managers.

Emma Rapaport: So we know that there are now almost 200 ETFs listed on the ASX in the last 20 years. But these days there are some slight differences between the types of ETFs out there. We've got your regular passive ETFs which is what we've been talking about uptil now, but we also have active ETFs and now even something called a smart beta or a strategic beta ETF. Can you quickly run us through the differences between all these products and how investors can tell the difference?

Alexander Prineas: Yeah, sure. So in the early days and certainly the first ETFs to list around about the turn of the century were purely passive index funds, and that remained the case for about a decade. Then we saw some strategic beta style of products which little bit of a sort of a halfway between passive and active management. So they try to employ some of the investment strategies developed by active managers, so focusing on quality stocks or focusing on value stocks. But rather than picking the stocks themselves they use a formula or an algorithm to pick the stocks. Maybe looking at price to earnings ratios or dividend yields or quantitative metrics of the companies.

So a lot of those have launched over the last you know since around 2009-2010 and they tend to cost a little more than passive index ETFs, but not a lot more. And then in the last few years we've seen quite a few active ETFs launched and actually we don't even call them active ETFs. We call them active exchange traded products, because they're really quite a different type of products. They're trying to beat the benchmark. They are charging generally lot higher fees. We know from many academic studies and studies that Morningstar has done over the years that the active – the average active manager struggles to beat the benchmark. Some of our favorite active managers like a Magellan or a Platinum can beat the benchmark and we're confident they can keep doing that. But we're not so sure about the average active manager so you've got to be careful that you're paying more, but not necessarily going to get outperformance.

Emma Rapaport: Right. We might just skip through some of the questions that have been coming in through from our audience members.

Alexander Prineas: Yeah, sure.

Emma Rapaport: So a question from (Rian) he asks, can you explain exactly how inverse ETFs work.

Alexander Prineas: Yeah, so inverse ETFs generally use futures to short the market. So essentially, they profit if – they profit when the market falls, when shares fall. And they make sorry, they – and they lose money when the market rises. So generally we think that, they can be used as a short term tactic. But just remember with an inverse ETF, it's the job of every company CEO and everybody that works for those companies to kind of do a good job and make the share price go up. So if you own an inverse ETF for the long run, you are essentially betting against the CEOs of all those companies. You're betting against everybody pretty much. And historically it's been a terrible strategy because the market has gone up in the long term and there's also costs associated with inverse ETFs in terms of that slightly higher management fee than a long index fund, a traditional index fund. And there's also costs around you know rolling over the futures contracts. So could be very useful as a short term trade when the market is expensive. But if you're holding them as a long term instrument maybe not a good trading strategy.

Emma Rapaport: So, John here he's asked, do ETFs published their management fees.

Alexander Prineas: Yes, they do. They publish their management fees. What they don't necessarily publish is their bid-ask spreads and that's again that's one of the things investors need to be cautious about with trading ETFs, is that because they trade on an exchange generally they trade with very tight bid-ask spreads that in periods of extreme volatility the spreads can widen a little not much most of the time, but a little. So if you're trading a lot that can add to your cost a little bit. And on some ETFs particularly active ETPs the spreads can sometimes widen quite a bit. So we generally advise people not to trade in the first 15 minutes of the day or in the last 15 minutes, because that's when a lot of those spread widening events occur. But at any time that you are trading just keep an eye out and make sure that the spreads are narrow before you put a trade in.

Emma Rapaport: And in terms of the actual fees themselves. Investors can go to the websites of the providers, but they can also go and check and compare the fees on our website as well.

Alexander Prineas: Yeah that's right. We have management costs and then there is new legislation coming through around fees and that's potentially going to show a little bit more granularity so that you can see what types of different costs there are. So that's something that hopefully we can display that info over time.

Emma Rapaport: So Allen asks, so Allen is a retiree with less than 1.6 million in his SMSF. He's a little bit worried that if Labor comes into power in May, they might talk about scrapping excess franking credits. And he's asked if you can recommend two ETFs that are high dividend.

Alexander Prineas: Well I can't recommend any ETFs for him, because I don't know his specific situation and what else is in his portfolio. I can talk about some general high dividend ETFs that we look at. So some examples of them might be things like Vanguard's, VHY or what's another one SPDR's, SYI. So these are products that sort of start with a traditional benchmarking approach, but then skew the portfolio towards stocks that pay a higher dividend. What you've got to look out for there though is as soon as you start to skew towards a high dividend. You're potentially introducing the risk of dividend traps. So it's that age old rule if something is high yield it might be high yield for a reason there is a risk there. And a good example of that was Telstra it has traditionally been a high yielding stock. That was because investors were quite bearish and nervous about the future prospects of Telstra. And as it turned out they cut their dividend and the share price performance wasn't good. So that is a risk whenever you're skewing your portfolio towards dividends. And then as for the franking credit situation that's very difficult to predict what happens there. Even if Labor wins the election there's a question mark about whether they will control the Senate. And exactly what the the final legislation looks like.

Emma Rapaport: So your advice is sort of sit tight, and just wait and see what happens first.

Alexander Prineas: It's really something that requires a highly specialized advice or at the very least advice knowing the specific situation that that reader is in and what else is in the portfolio and so on. So yeah, I can't really answer that question fully.

Emma Rapaport: (Pierre) asks is it best to invest in an ETF via a middle man like Stockspot or to – and to essentially cop an extra fee or is it better to create your own ETF portfolios using one of the providers we talked about iShares, Vanguard.

Alexander Prineas: I mean it depends on the investors' amount of time that they can devote to it and the level of familiarity they have. So any time you add in a middle man, yes as you say there is going to be a cost to that but if you wouldn't invest at all without doing that or if you didn't have the time. Then these types of services can be useful for investors. Again it's probably one where somebody sort of has to weigh that up themselves what is their personality type, what are their sort of behavioral sort of preferences and their investment preferences. So without kind of knowing a bit more about that it's difficult to answer specifically, but just anytime you add something, add in a middle man just be looking at what you're getting and what you're paying for that.

Emma Rapaport: A bit of a technical question from Ryan. He asks hedge or not to hedge and I am going to throw in a question, what is a hedged ETF.

Alexander Prineas: Yeah, sure so whenever you buy a global equity ETF, you're buying companies that are in say America or in Europe and so on. But you're also getting exposure to foreign currencies. So hedged ETF will iron out a bit of that foreign currency exposure. So it doesn't iron out all of it because you know the individual companies may still have their own currency risks, but it does iron out a fair chunk of your your offshore currency risk.

Emma Rapaport: And does Morningstar have a view on I guess maybe where the Australian dollar heading whether or not it's better to be hedged or unhedged at the moment.

Alexander Prineas: Look there are so many views out there on which way the Aussie dollar is going I'm not going to add to that. What I will do is maybe put a bit of a long term perspective on these things. So generally what we've found is that when markets are say crashing when there is fear out there the Aussie dollar is often falling and that's because our economy is heavily dependent on commodities. We're also quite internationally linked in terms of trading. So when equity markets are falling the Aussie dollar is falling. So that's actually already providing you with a bit of a hedge, its cushioning the blow. So if you went into a currency hedged ETF, when markets are falling you may not be getting the diversification of that protection from the Aussie dollar falling as well. There is certainly no guarantee that relationship always holds, but it certainly has done over the long run and so generally in Morningstar model portfolios and so on we've tended to use more unhedged than hedged. But again it's…

Emma Rapaport: Individual circumstances.

Alexander Prineas: Yeah, exactly.

Emma Rapaport: Great. Well I am just going to – I'm going to close because we're coming up to time now. We want to thank everyone who joined us for today's webinar. And a special thanks to everyone that sent in questions. If we couldn’t get to your questions today, send them in and Alex will endeavor to answer them later. Keep an eye out for our next Friday Fundamentals and you can watch this video and other great videos on Morningstar.com.au.

 

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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