9 things to know before you invest in ETFs | BetaShares Insights

9 things to know before you invest in ETFs

BY BetaShares ETFs | 1 August 2017
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With the Australian Exchange Traded Fund (ETF) industry valued at over $35B at the end of 2017 and more than 200 different exchange traded products available on the Australian Securities Exchange (ASX), it’s unsurprising that more and more investors are starting to adopt ETFs as core building blocks of their portfolios.

One reason why this trend may be set to continue is that exchange traded products have evolved from being more than just index tracking strategies. They can now provide a simple way to add exposure to particular asset classes, such as gold (e.g. using QAU). They can also be used as a tool in a specific strategy, such as an investor looking for broad Australian sharemarket exposure but with reduced market volatility (e.g. using AUST).

If you’re uncertain about anything in the above paragraph, that’s okay! We’re increasingly seeing new investors turn to ETFs as a starting point for their portfolios. And for good reason: ETFs are low-cost, offer instant diversification and transparency.

The following nine tips may help beginner ETF investors get started:

1. Understand an ETF’s basic structure and liquidity before you start to trade

Before you consider investing in ETFs, you’re probably going to want to know what they are. Before you read on, take a minute to watch the below video, which explains the basics of what an ETF is:

So, ETFs do work a little differently to the standard shares you might be more familiar with, or already trading in. Those differences might take a while to wrap your head around, but ultimately lead to a number of advantages for investors. They are actually simple to use products and easily accessible to more investors of all experience levels, plus they offer liquidity and transparency. ETFs are also more cost-effective, and if you’ve got a self-managed super fund (SMSF), ETFs can be purchased within your SMSF.

Let’s talk about the liquidity of ETFs briefly. One of the most critical differences you should be aware of is that, unlike shares, the size of the ETF in terms of assets under management, the daily volume traded and the volume of units quoted ‘on screen’ is not indicative of liquidity. This is because an ETF is an open-ended investment fund.

An ETF’s open-ended structure means units of an ETF can be created or redeemed by market makers, as opposed to company shares which, by definition, can only have a fixed amount of stock outstanding on any given day. As such, the supply on offer for an ETF can be adjusted to cater to the demand of the market. Therefore, the ETF fund size, daily volume traded and ‘on screen’ liquidity are not meaningful when assessing the liquidity of an ETF. An ETF’s liquidity is mainly determined by the liquidity of the underlying holdings of the fund. See below for an example of this in operation, in which the daily liquidity is reflected by the daily average volume of the underlying holdings for BetaShares FTSE RAFI Australia 200 ETF (QOZ), rather than its ‘on screen’ volume:

Which brings us back to the simplicity and accessibility of it all; in terms of how to actually buy and sell ETFs, unlike traditional managed funds, you do not require an application form to purchase an ETF, instead, once you have a brokerage account, you simply buy and sell units as you would any share on the ASX.

2. Know what the NAV is, and then use the Indicative Net Asset Value (iNAV) to help determine the price to trade

There are a couple of tools available to investors to help them determine the right price to buy or sell an ETF. The most basic of these is the NAV or “net asset value”. All ETF providers are required by law to list the net value of the ETFs underlying holdings – or NAV – on their website, and while fees and other costs mean you won’t get to trade in the market at exactly that price, you can use that as a guide to ascertain the ‘fair value’ of the product at the beginning of the trading day.

From there you can make use of the iNAV. To help determine a fair price to buy or sell an ETF you are able to refer to its indicative net asset value or “iNAV” (if available) – this is as opposed to a traditional share in which you compare your preferred ‘buy’ price with the price being offered on the screen.

The iNAV is the estimated intra-day ‘fair value’ of the ETF (which is the price per unit of the basket of underlying securities held by that particular ETF less any liabilities such as management fees) which updates frequently during the day in real time. iNAVs bring intra-day pricing transparency to ETFs in contrast to unlisted managed funds, for which net asset values are determined just daily (or sometimes less frequently) once the trading day ends.

INAVs for applicable BetaShares Funds can either be found on our website on the respective product page, as seen in the screenshot below (for our YMAX fund), or via an ASX code which is specified on our website for certain funds.

3. Is the ETF Currency Hedged or Unhedged?

Something you’ll need to consider with ETFs which track international shares is whether your investment is “hedged” or “unhedged” when it comes to the foreign currency. The impact of currency is a genuine potential risk for ETF investment – you might well invest prudently and see the stocks in your ETF all go up, which would result in a profit for you, were it not the case that the currency involved in the ETF goes the other way, leading to a reduction on the available profit or even, in an extreme scenario, a loss!

All ETFs which invest in international shares will be currency Hedged or Unhedged, and it’s important to decide how you wish to invest. For example, if you are solely wanting to take a view on the value of the underlying international shares, without having to worry about the direction of the foreign currency and the Australian dollar, you are likely going to want to invest in a “hedged” ETF. If, on the other hand, you would like to include the relative performance of the foreign currency to the Australian dollar as part of your investment you may be happy to invest in an unhedged way. Please note that, if you invest in an unhedged product, should the value of the foreign currency appreciate against the AUD, this will be a net benefit to the performance. Conversely, should the Australian dollar appreciate against the foreign currency, the performance of the unhedged product will be worse than the underlying performance of the shares themselves.

So, if you are investing in international ETFs, make sure you also keep a close eye on the currency behaviour and how you wish to take a view on that.

4. What’s a Short Exposure?

There are certain exchange traded products that provide a short exposure to the sharemarket. Where traditional index-tracking funds move inline with a benchmark, a short exchange traded product is designed to go up when the benchmark falls, and vice versa. This allows investors to simply take a short position via such a product.

As with all short positions, this might seem like a risk-filled investment, but there’s one significant benefit to it; if you’re predicting a fall in the sharemarket, a short exposure is a way to hedge the risk across your portfolio and potentially generate profits from a falling market.

BetaShares currently offers three short funds. – two covering the Australian market (Australian Equities Bear Hedge Fund (BEAR) and Australian Equities Strong Bear Hedge Fund (BBOZ)) and one covering the US market (US Equities Strong Bear Hedge Fund (BBUS)).

5. Understanding bid & offer spreads

All exchange traded and unlisted investment funds are subject to bid and offer spreads (known as buy/sell spreads for unlisted funds). In the case of ETFs, a bid/offer spread is the difference between the NAV of the Fund and the price at which the ETF can be bought or sold on the ASX. A ‘spread’ is a Market Maker’s compensation for the time and financial risk they bear by making markets and enhancing liquidity i.e. acting as a buyer and seller of ETF units on the exchange and creating and redeeming units based on investor demand. Spreads for each fund vary as they are largely dependent on liquidity of the underlying securities. In general, the more liquid the security, the tighter the spread. Market Makers also seek to maintain tight spreads to ensure they do not give their competition the potential to ‘arbitrage profits’.

Bid/offer spreads for all BetaShares Funds can be found on the BetaShares website, on the respective product page, as seen in the screenshot below:

 

Spread offer

6. Know the difference between ‘market orders’ and ‘limit orders’

When placing an order through your broker, whether it be for a share or an ETF, you have the option of placing your trade as a ‘market order’, in which you are agreeing to bid on whichever price the market is willing to pay, or a ‘limit order’ in which you determine the price you are willing to bid.

The risk with the market order is that if there are many orders placed at the same time, relative to the demand on offer (i.e. a previous investor has placed a large order which momentarily depletes the volume offered at the current market price), your trade runs the risk of being filled with the next best market offer and this may be worse than the best price possible. A volatile market may also cause the iNAV of the ETF to fluctuate and spreads to widen, which also may lead to bids being filled at undesirable prices.

To avoid this risk, you may wish to place a ‘limit order’. Although you may run the risk of your order not being filled immediately, you still avoid the risk of getting worse than your desired price for the ETF.

7. Time when you buy/sell an ETF

Investors may also wish to avoid trading near the market open and close. This is because Market Markers can experience higher risk at these times, which may result in wider than normal spreads. At the market open, Market Makers look to determine the accurate pricing of the ETF’s underlying securities, taking into account the fact that only some, but not all, of the securities, have commenced trading and therefore have current prices available. This occurs as companies commence trading on the exchange in tranches on a staggered basis, as shown in the diagram below:

when to buy and sell Source: MarketIndex.com.au – how to buy shares

The higher risk is experienced by Market Makers when markets open and near market closing time, as prices of securities tend to fluctuate more at these times. This volatility occurs around the market close as the ‘matching period’ approaches (all trades that take place on the close transact at a price determined by the market, regardless of what price an investor bids or offers). Market Makers bear a higher risk in pricing at this point, which can lead to wider than normal spreads.

On this basis, investors should be mindful of trading around market open and close periods.

To repeat what we said in Tip #1, something that many observe with ETFs is that the volume of trading, i.e. buying and selling during the day, may be low, which may lead some people to believe that ETFs have relatively low liquidity. This is not the case at all. ETFs have an open-ended structure, meaning that the liquidity of ETFs is beyond the amount of on-screen volume that investors see on the trading screen. As a rule of thumb, the liquidity of ETFs is at least as great as the liquidity of all the underlying assets that comprise an ETF.

8. ETFs can help deal with market volatility

Volatility in the markets is something that is increasingly commonplace, and ETFs are a useful weapon to help manage this risk. 

One of the major advantages of ETFs is the fact that they typically trade very closely to NAV, as described above. By contrast, a listed investment company – or LIC – provides no formal mechanism to ensure that the bid-offer prices are close to the NAV and this means that when there’s a great deal of selling going on – a “panic” – there is a real chance that the traded price for the LIC will fall well below the LIC’s NAV, imposing costs on anyone who wanted to sell out as quickly as possible.

9. What happens to my assets in the event of a product issuer’s bankruptcy?

The ETF structure is generally very investor-friendly, and includes protection mechanisms for the investor. Put simply, in the unlikely event that a product issuer goes bankrupt, the product issuer’s creditors aren’t going to be able to access the ETF’s assets.

ETFs have the same legal structure as a traditional managed fund, and this means that the assets that form the underlying ETF are held on trust for the benefit of investors, and do not form part of the assets of the product issuer. Normally, to ensure additional separation, assets will normally be held by an independent third party known as a ‘custodian’, which has been appointed by the ETF issuer, but is not part of the same organisation.

BetaShares is a leading Australian fund manager providing a range of exchange traded funds to our clients. You can find out more about ETF basics in this article. For more information about any of our products, explore our website or contact us today, the friendly BetaShares Client Services team is always here to help.

12 Comments

  1. robert mcwilliam  |  August 2, 2017

    Useful, thank you

    1. Ilan Israelstam  |  August 9, 2017

      Glad it was helpful

  2. Jordan Carter  |  August 2, 2017

    Very good- Thanks

    1. Ilan Israelstam  |  August 9, 2017

      Glad you enjoyed it

  3. frank micale  |  August 3, 2017

    I would like to speak to someone regarding HVST….EFT
    Thanks frank….0407163512

    1. Ilan Israelstam  |  August 11, 2017

      Of course Frank – one of our client services team members will give you a call shortly

  4. Brett Richardson  |  August 10, 2017

    Hi, I have a question regarding your HVST fund.

    Specifically, how you manage the value and time decay factor of the investment units. Given the fund, as is my understanding, rotates through the top 50 ASX listed stocks to achieve the funds objectives – there is a high risk that the capital invested in the preceding period will be higher than in the next period. As the value of the stocks held reduces by the amount of the dividend (assuming ECM theory plus the exogenous variables) thus the amount of capital available to invest in the next best dividend paying stocks will be less. It would seem inevitable over time, despite the hedging with SPI futures based on whatever VaR/tail risk scenarios etc that are utilised – over time, the funds NAV will eventually be a lot less than what it started at, unless there is a fresh injection of capital.

    As an aside, the nominal value of the monthly distribution will decline over time as well.

    In effect, at best, the ETF units hold a constant variance over time which is (hopefully) a slow decay. So really all that will happen is I get my money back distributed as a kind of hybrid derivative of an annuity just with higher risk!

    For example, I invest $10,000 back in May 2017 @ $20.50/unit. Total outlay which today (10th Aug) would be worth $8,726.74 (give or take a few cents) Total LOSS $1,273.26 or 12.73%, add back the distributions – ($83.59, $80.94, $75.77, $73.05 = $313.35) you’ll note the declining NOMINAL distributions over the 4 months.

    Total LOSS $1,273.26 – $313.35 = $959.91 or 9.56% not including transactions and spread costs for the market maker(s) – I also note during the period the risk management position increased from 9% to 45% of short SPI futures.

    If the performance tracks like this for much longer it would appear a high risk proposition for little to zero chance of upside return to a neutral starting point.

    Rather rich, or not so, perhaps to charge 0.8%.

    I realise I am not privy to the underlying proprietary mechanisms of the fund, nor should I be and I realise I am judging the performance of the fund over a very short period.

    I look forward to a response, my email is below!

    1. Ilan Israelstam  |  September 5, 2017

      Brett,
      In a situation where an investor takes out all the distribution income as cash (i.e. rather than reinvesting some/all of it) you are absolutely right that unless the total return of the investment is higher than the income return (which is currently around 11%) then, by definition, capital value will decline. You are also right for the same reason that in this situation the nominal value of the monthly distribution will decline (although again a reinvesting investor will benefit because they will be buying more units at a lower value then previously). For these types of investors you are right that the fund can be seen as a type of variable annuity, although of course with very high franking credits (double that of the Australian sharemarket) which for low tax-payers is a form of ‘free’ alpha.

      These issues and more are detailed in a paper we wrote about HVST – which you can read here – https://www.betashares.com.au/wp-content/uploads/2017/06/Revisting_HVST_Strategy_final.pdf

      Perhaps you can read this, and if you any further questions or queries you might want to call our client services team on 1300 487 577

  5. Peter Rickards  |  August 21, 2017

    You need to understand what a bid is- ie to buy and an offer – to sell. You have got it wrong in your point 4. You should have said you run the risk of getting filled at the next best offer NOT bid

    1. Ilan Israelstam  |  October 3, 2017

      Thanks for picking this up – you’re right

  6. Hi
    Recently, an ETN that bets on the VIX being low, lost about 80% of its value and was closed out. If the S&P 500 declines 50% can you please explain what would happen to the a geared ETF like GGUS? What are the processes that will take place?

    Thanks very much.

    1. Isaak Walkom  |  May 28, 2018

      Hi KB,
      Thanks for your message and apologies for the delay in getting back to you.
      I would just first point out that the VIX is inherently more volatile than the S&P 500 and a product like the one mentioned would not be able to trade on the ASX like GGUS does. In the past 50 years, the S&P 500 has not experienced a daily decline of 10% or more. If the unit price of the fund were to reach a level where it was unable to trade as desired, a unit consolidation would be considered.
      If you would like some more information around this, please feel free to call BetaShares Client Services on 1300 487 577.
      Kind Regards

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