ETFs: Greater Choice Means More Homework
Australian investors have been enthusiastic adopters of exchange-traded funds (ETFs), with the local ETF market growing to $28.8 billion in May 2017, up by more than $5 billion over the last 12 months.
As investors increasingly take advantage of the various benefits that ETFs can offer, fund managers of various stripes are adding more and more options to the ASX's exchange-traded product menu. Again, over the last year, the number of available exchange-traded products has grown from 135 to 159.
This greater number of ETFs is a boon for investors, as they have greater choice when it comes to implementing their investment strategies.
For instance, ETFs have traditionally been market cap-weighted index funds used to gain broad market exposure. These index ETFs have typically been a great option for investors looking to build the diversified core of their investment portfolios with broad asset allocation across shares and bonds.
However, not all ETFs are broad-market index funds, and this means investors must do their homework thoroughly before deciding whether a particular product's investment style suits their needs.
For example, not all index funds provide broad market exposure to a large index like the S&P/ASX 300 or the S&P 500 in the US. Some products provide exposure to companies based on their size, such as ETFs investing in the 50 largest companies on the ASX, or some of the smallest. Another example might be an ETF that tracks an index dedicated to a specific sector, like financial services or health care.
While investors can use the characteristics of these narrower indices to implement an active tilt in their portfolio, it is important to wary of using these kinds of funds as a substitute for broadly diversified options designed to capture market returns.
Aside from using index ETFs to implement their chosen portfolio strategy, investors have at their disposal a growing set of exchange-trade products that use active strategies. These are commonly rules-based funds, which hold companies that fit a certain set of criteria, such as displaying low price volatility. When doing their homework, investors should also be clear on whether an ETF that tracks an index is employing an active, rules-based strategy designed to outperform the market, or tracking market performance.
Although there are many aspects of an ETF that investors should consider before investing in it, one enduring textbook rule is to ensure that it aligns with your broader investment strategy, and the goals you have set for your portfolio.
Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.