There’s no doubt that exchange traded funds [1], or ETFs, are the hot new product in global markets. Money invested in ETFs globally has grown from less than US$100 million a decade ago to more than US$1.2 trillion.
In Australia, the boom was relatively late in coming, but it has arrived in earnest in just the past few years. By the end of August, there were already 57 ETFs or ETCs (exchange traded commodities) available on the Australian Stock Exchange with a combined market capitalisation of $5.2 billion.
ETFs (which are simply listed index funds that track popular benchmarks such as the S&P/ASX 200, emerging markets, the financial or resource sector, or even gold) are increasingly popular due to their relatively low management fees, high diversification, and apparent simplicity and transparency.
That said, sometimes looks can be deceiving. In Europe and the United States, investors are discovering that ETFs can have hidden risks, often due to embedded complex derivative structures or a failure to track their benchmarks in ways seemingly promised.
How risky then are the ETFs available in Australia?
The good news is that most ETFs available in Australia remain relatively simple and transparent. But as our range of ETFs grows, this may not always be the case. So let’s dig below the surface to uncover a few layers of potential risk that you need to be aware of.
Risk one: Liquidity
Although in theory ETFs should trade close to their net asset value on the Australian stock exchange, bid-offer spreads for smaller and lightly traded funds can sometime be wide, and this means – as with any illiquid small stock – investors can get poor prices if placing large market orders at times of insufficient market depth.
Unlike small company stocks, however, ETFs do have a clear objective value – the net asset value (NAV) of their underlying benchmark index. And ETFs are structured so that there is an incentive for professional traders to keep quoted prices close to the NAV. What’s more, the ASX has set up a series of financial incentives for traders to encourage this process. In the main, bid-offer spreads for even small ETFs are narrowing. Moreover, most of the large ETFs on the ASX now have quite tight bid-offer spreads and decent trading volumes.
If you own a smaller ETF, there is something you can do on quiet illiquid days: the trick here is to use limit orders, with prices set around the midpoint of the best bid and offer. With patience and some haggling, trades near the ETF’s NAV should still be possible from at least one of the ETF’s competing market makers.
Risk two: Tracking error
Tracking error, or the risk of the ETF not following its benchmark index, is another risk. For most conventional ETFs that hold all or a representative sample of the securities within a benchmark index, this is rarely a problem. But problems have emerged for leveraged and inverse ETFs. The good news is that these don’t exist in Australia – yet. Keep your eyes peeled.
Risk three: Counter party risk
This is the risk that either the ETF provider or one of their counter parties fails, threatening the return of capital to investors. Again this risk is mitigated by the fact that securities underpinning an ETF are usually held by a third-party custodian who is charged with selling them to pay back ETF investors if the provider goes bust.
That said, there’s an element of counter party risk where these ETF providers lend out their security holdings to other professional investors – who often want to short these stocks. While this can earn the ETF provider income and keep ETF costs down, a problem arises if the borrower gets into financial difficulty and can’t give back the stock.
Luckily, most of Australia’s major ETF providers don’t engage in stock lending – at least for ETFs covering the Australian market. Vanguard and BlackRock’s iShares do engage in some security lending within their international ETFs, but in these cases there are risk limits on the extent of lending and on the quality of borrowers. Most importantly, borrowers are required to post collateral at least equal in value to that of the securities lent, with these values regularly adjusted in line with market prices.
Risk four: Synthetic ETFs
Trickier considerations arise for synthetic ETFs – or where an ETF provider pays a third party to provide index returns via a derivative or ‘swap’ agreement, rather than using the conventional approach of simply owning the underlying securities that make up the benchmark.
Synthetic derivatives have benefits in that tracking error – compared with conventional indexing through securities ownership – can often be lower, but the investors are then exposed to ‘counter party’ risks should the swap provider fail to live up to their part of the agreement.
In Australia, however, these risks also seem relatively well contained. For starters, virtually all Australian-listed ETFs don’t use synthetic replication – whereas in Europe up to 50% of ETFs do.
Here, moreover, the ASX also requires that the value of derivative exposure for a synthetic ETF be no more than 10% of its net asset value – meaning 90% of its value is underpinned by the conventional method of holding physical securities from the benchmark index.
The ASX also requires that derivative counter parties be of sufficient creditworthiness, by either being authorised deposit-taking institutions or foreign banks that meet ASX requirements.
All up, the Australian ETF landscape is still in its infancy, but rapidly evolving. That means local investors have yet to be exposed to the more complex ETFs causing concern in other more mature ETF markets. Thankfully, it also means our regulators are in a position to learn the lesson of overseas experience and keep tight control of the risks investors will be exposed to.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Also in today’s Switzer Super Report
- Peter Switzer: Six reasons why it’s better to invest for the long term [2]
- Tony Negline: How the contribution rules change at 65 [3]
- Charlie Aitken: Have we hit the bottom? [4]