In my last blog piece I set out what I thought were the top 6 tips for trading ETFs. In my daily contact with clients, I am often asked a series of the same questions from a wide variety of investors. As such, for this post for the BetaShares Academy I thought I’d take some time to debunk some of the most common misconceptions that come up when discussing ETFs with investors and their advisers.
1. Myth: ETFs are risky investments
Think of an ETF as just another tool in your investing tool box. An ETF as an investment structure is no more risky than an equity, a managed fund or a LIC. As we often point out, ETFs cover all types of asset classes and exposures from currencies, commodities, fixed income and equities. So instead of seeing an acronym and thinking that it must imply more risk, we encourage investors to consider their risk profile when determining how to use ETFs within their investment portfolios and to consider what the actual underlying exposure of an ETF is. For example, an ETF holding 200 of the largest stocks on the ASX (like our QOZ product) , will have a very different risk level and volatility than an ETF which tracks the price of small companies on the ASX!
2. Myth: ETFs are only for passive investors that want to replicate the market but not beat the market
ETFs are known as being passive because, in Australia, ETFs do not have a manager actively managing a portfolio or constantly changing positions at any given time when the manager sees fit (there are actually actively managed ETFs overseas, however we’ll leave that for another time!). ETFs are considered passive because an ETF will usually track an index that has been constructed by one of the global index providers i.e. S&P, MSCI, FTSE, etc. Whilst it’s true these types of ETFs would very rarely outperform the indices they are based on, adding an ETF as part of the portfolio construction can give you access to asset classes that you otherwise may not have access to, or allows you to “overweight” or tilt a portfolio to a sector such as financials or resources. When used in conjunction with a broad market ETF, this could lead to potential outperformance over a broad market exposure alone. In other words, just one ETF will give you replication of an underlying index, but combined with other ETFs (or for that matter direct equities or managed funds), you give yourself the opportunity to add alpha and construct complete portfolios. We like to call this “generating alpha from Beta”!
3. Myth: All ETFs tracking similar indices are the same
As the ETF market evolves and develops, there can be expected to be multiple exchange traded funds tracking a similar index. However, there can be quite a few differences that you may want to take a closer look at besides management fees, buy/sell spreads and volume. You should also take a look at which particular index the ETF is benchmarked against, whether the ETF is using a market cap or fundamentally weighted approach, and whether there may be any tax advantages by using one ETF or another. These slight differences could lead to additional performance, or savings on fees and/or taxes, which would lead to more money in your pocket.
4. Myth: ETFs trade like a stock, and aren’t liquid!
ETFs are traded on an exchange like a stock, but unlike stocks, ‘on-screen’ volume is not a true indicator of liquidity. When trading a stock, liquidity is a primary concern since you would like to be able to sell the stock when needed, or purchase the stock when wanted without pushing the price up or down. However when purchasing or selling an ETF, the volume traded of the ETF is not a true indicator of its liquidity. ETFs are required to have market makers that are present to purchase or sell your units when you need to buy or sell, and ETFs are able to issue additional units or redeem units as demand rises or falls. These features facilitate ETF liquidity, and aren’t present for ‘ordinary’ stocks. This is why we always say that the actual liquidity of an ETF is based on what the underlying asset is, and as long as the underlying is liquid, the volume traded of an ETF is not a true indicator of liquidity. Because this is such a persistent myth, we’ve actually done a dedicated BetaShares Academy post on this topic.
5. Myth: ETFs don’t actually own assets
The vast majority of ETFs in Australia are asset backed and hold the actual underlying investments you are exposed to. There are some commodity ETFs which track assets that are simply not feasible to hold directly (e.g physical oil or grains), but even these are backed by cash. In either case, your ETF is most definitely holding assets!