5 things to know before you invest in ETFs

BY Aditi Grover | 1 August 2017
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ETF Questions

With the Australian Exchange Traded Fund (ETF) industry just shy of $30B in assets and ETFs now being more actively traded than stocks in the US*, 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 now additionally 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 sharemarket exposure but with reduced market volatility (e.g. using AUST).

We’re increasingly seeing less experienced investors turn to ETFs as a starting point for their portfolios. And for good reason: ETFs are low-cost, offer instant diversification and transparency. As a result, I thought I would take the time to write on the “ETF basics”.

The below 5 tips may help beginner ETF investors get started:

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

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 an ETF’s 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. This is demonstrated by the example below, in which the daily liquidity is reflected by the daily average volume of the underlying holdings for BetaShares FTSE RAFI Australia 200 ETF (QOZ):

*https://www.bloomberg.com/news/articles/2017-01-12/stock-exchanges-turn-into-etf-exchanges-as-passive-rules-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. Using the Indicative Net Asset Value (iNAV) to determine the price to trade

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 overlay your technical analysis of the stock with market depth ‘on screen’ i.e. – the queue of all the buyers and sellers on 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 multiple times per minute 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 QOZ fund), or via an ASX code which is specified on our website for certain funds.


3. 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 ETP 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 ETF 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
4. 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.

5. 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.

I hope these tips have helped and, if you have any other questions, the friendly BetaShares Client Services team is always here to help. Feel free to give us a call!

10 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

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