Exchange-traded funds (ETFs) have gained significant traction among Australian investors in recent years.
Offering a diversified portfolio of assets, ETFs are traded on stock exchanges much like individual stocks, making them an accessible and versatile investment vehicle.
The ASX ETF market has over A$190 billion in funds under management (FUM) as of April 2024, a stark contrast to less than A$10 billion a decade ago (Figure 1).
There are currently 341 ETFs listed on the ASX with over 2 million investors holding ETFs in their portfolio.
However, like any investment, ETFs come with their own set of advantages and disadvantages, which this article will be tackling.
Figure 1: Australian ETP trends (Source: ASX)
Advantages of ETFs
One of the primary benefits of ETFs is diversification.
By investing in a single ETF, investors gain exposure to a broad range of assets, which can include stocks, bonds, or commodities.
This diversification can mitigate risk, as the performance of the ETF is not tied to a single company or sector.
For instance, the SPDR S&P/ASX 200 ETF (ASX: STW) provides exposure to the top 200 companies listed on the ASX (Figure 2).
Figure 2: Excerpt from SPDR S&P/ASX 200 ETF Factsheet (Source: ASX)
This broad exposure helps investors avoid the pitfalls of putting all their eggs in one basket, thereby spreading risk across various assets.
ETFs also offer liquidity and flexibility. Since they are traded on exchanges, investors can buy and sell ETF shares throughout the trading day at market prices.
This intraday trading capability allows for timely entry and exit points, which is advantageous compared to mutual funds that are priced only at the end of the trading day.
This liquidity makes ETFs particularly attractive to active traders and those looking to take advantage of short-term market movements.
Cost-effectiveness is another significant advantage. ETFs typically have lower management fees compared to mutual funds, making them a more cost-efficient way to diversify a portfolio.
For example, the Vanguard Australian Shares Index ETF (ASX: VAS) boasts one of the lowest expense ratios in the market, making it an attractive option for cost-conscious investors (Figure 3).
Figure 3: Vanguard Australian Shares Index ETF ( Source: Vanguard Website)
Lower fees mean that a larger portion of an investor’s capital is working for them, potentially leading to higher returns over the long term.
Transparency is also a key benefit of ETFs. The holdings of most ETFs are disclosed daily, providing investors with clear visibility into the underlying assets.
This transparency allows investors to make informed decisions and better understand the risks associated with their investments.
Additionally, ETFs can be a tax-efficient investment vehicle.
The structure of ETFs generally results in fewer capital gains distributions compared to mutual funds, which can lead to lower tax liabilities for investors.
Disadvantages of ETFs
Despite their benefits, ETFs are not without drawbacks. Market risk is a significant concern, as the value of an ETF can fluctuate with the market.
While diversification can reduce individual stock risk, it cannot eliminate the systemic risk inherent in the market.
For example, during a market downturn, even a well-diversified ETF can experience significant losses. Investors must be prepared for the possibility of volatility and should consider their risk tolerance before investing in ETFs.
Tracking errors are another potential issue. ETFs aim to replicate the performance of their underlying index, but discrepancies can occur due to various factors such as fees, management errors, or liquidity issues.
These tracking errors can result in the ETF underperforming its intended benchmark. For instance, an ETF designed to track the ASX 200 index might not perfectly match the index’s performance, leading to potential discrepancies in expected returns.
Additionally, while ETFs offer liquidity, they can still be affected by market conditions.
During periods of high volatility or low trading volumes, the bid-ask spread for an ETF can widen, leading to higher transaction costs for investors.
This scenario can be particularly pronounced in niche or sector-specific ETFs, where trading volumes may be lower. Investors should be aware of the potential for increased costs during volatile market periods and plan their trades accordingly.
Complexity is another factor to consider. While ETFs are often marketed as simple investment vehicles, the reality can be more complex.
Some ETFs, particularly those that use leverage or focus on specific sectors or commodities, can be difficult to understand and come with higher risks.
For instance, leveraged ETFs aim to deliver multiples of the performance of the underlying index, which can lead to significant gains but also substantial losses. Investors should ensure they fully understand the structure and risks of any ETF before investing.
The Australian Context
For Australian investors, it is important to consider the local context when investing in ETFs.
The Australian ETF market has grown significantly, with a wide range of options available that cater to different investment strategies and preferences (Figure 4).
Figure 4: ETP Market Growth (Source: ASX)
However, investors should be mindful of the specific risks and opportunities presented by the Australian market.
One consideration is the impact of currency fluctuations. Many Australian ETFs provide exposure to international markets, which means that currency movements can affect returns.
For example, an Australian investor holding an ETF that tracks the US S&P 500 index will be exposed to changes in the exchange rate between the Australian dollar and the US dollar.
Currency-hedged ETFs are available to mitigate this risk, but they may come with higher costs.
Regulatory considerations are also important. The Australian Securities and Investments Commission (ASIC) regulates ETFs in Australia, ensuring that they meet certain standards of transparency and investor protection.
However, it is still crucial for investors to conduct their due diligence and understand the specific characteristics and risks of each ETF.
Get Deeper Insights
The latest and most reliable information from experienced sources, that are completely unbiased are now available through a Paid Membership. Sign up here for a more trustworthy source of well-researched and independent information for investors.Â
-------
Disclaimer
The information or opinions provided herein do not constitute investment advice, an offer or solicitation to subscribe for, purchase or sell the investment product(s) mentioned herein. It does not take into consideration, nor have any regard to your specific investment objectives, financial situation, risk profile, tax position and particular, or unique needs and constraints.
------
About Samso
Samso is a trusted platform that equips dedicated investors with up-to-date industry knowledge and insights from top CEOs and thought leaders. By staying informed on business advancements and market trends, investors can enhance their financial decisions through a combination of expert guidance and their own research.
Comentários