There’s a growing number of exchange-traded funds (ETFs) on the Australian Stock Exchange, which means a growing number of people are wanting to know how to choose the best ETFs.
Like Warren Buffett, Six Park loves ETFs as an investment vehicle. They typically provide low-cost, highly liquid, highly diversified and immediate exposure to specific asset classes
But not all ETFs are created equal.
The ETF marketplace is becoming more crowded: At the end of March 2019, there were almost 200 exchange-traded products listed on the ASX, representing more than $45 billion of assets under management. That’s twice as many options as there were just five years ago.
That means it’s becoming harder to evaluate the products you’re thinking about investing in. Six Park’s investment team spends significant time analysing the ETFs available in Australia and ensuring the ETFs we use to construct our clients’ investment portfolios are the best in the market. And it’s not a simple exercise.
How does Six Park choose the best ETFs?
Six Park director of strategy and analytics David Blumenthal is responsible for compiling the ETF analysis presented to Six Park’s Investment Advisory Committee at each meeting. This analysis helps Six Park’s IAC members assess new offerings against existing products and ensure portfolios contain the best ETFs for clients.
Dave has worked across the finance, investment and asset management sectors for more than 20 years, including as a director of the Australian division of a US$5billion global alternative asset investment manager. He began his career in the corporate advisory division of Credit Suisse and has also held roles in principal investment and private equity at NM Rothschild and Sons and JP Morgan Partners, where he first worked with Six Park co-founders Pat Garrett and Brian Watson AO.
“I always had a huge amount of respect for Brian and Pat so I was all ears when they approached me with the idea of a robo-adviser,” Dave recalls.
“At the time, robo-advice was a very new space. The idea resonated for me because I knew from personal experience that it was very hard to get good financial advice at an affordable price point.”
“As it happens, my major finance honours project at Monash University focused on whether it is worth paying for professional investment advice to try to beat the market. My conclusion at that time was that it’s extremely hard to outperform a passive investment strategy. All that theory still holds true. Study after study after study shows that diversification, strong asset allocation and low fees are hard to beat – and that is what Six Park is all about.”
He says the changes in the ETF landscape since Six Park was founded in 2014 have been massive.
“There’s been an explosion in both the number of ETFs available and the percentage of people investing in the sector,” Dave says.
“At the time we launched it was an area that people were beginning to appreciate but the growth has been immense. Back in 2014, there was less than 100 ETFs on the ASX and the sector choice was far more limited. For example, there was no ETF covering global infrastructure – whereas nowadays there are two dedicated infrastructure funds to choose from.
“We’re seeing more ETF providers competing with each other to service an asset class or area that they discover may be unserviced or underserviced, so the landscape is much more extensive. That’s great in some ways because it helps put pressure on fees, but it’s also more complicated, because there’s more choice, so how do you choose?”
Not all ETFs are created equal
ETFs can vary in a number of important ways. Six Park’s ETF analysis considers factors such as:
- The track record of the ETF and its issuer
We’ll touch on some of these factors in more detail later – but Dave says the very first consideration when evaluating ETFs should be what asset classes you want to include in your portfolio.
“At Six Park, we come at it from an asset allocation perspective first – that means determining the asset classes that we believe our clients need exposure to, and in what proportions.
“To do this, we start with a mean-variance optimisation model, which in simple terms is a data-driven process designed to determine the best asset mix for a given level of volatility or risk.”
Dave built Six Park’s optimiser model, which examines historical and projected asset returns and volatility and then generates recommendations on the most efficient asset allocations for each of our portfolios.
“That’s one data point – it’s a key one, but as with any mathematical exercise, the inputs can affect the output significantly, so it requires interpretation and oversight, which is where our investment committee comes in. We overlay their views and deep knowledge of world markets to come up with a considered and prudent asset allocation mix for each portfolio.
“Once the asset allocations are decided upon, we then move to considering which ETF is best for the asset classes that have been selected.”
What follows is a huge data gathering and analysis exercise, especially for asset classes such as international equities and Aussie shares, which are now represented by so many different ETF offerings.
“We consider a range of factors – the suitability of the ETF’s strategy and chosen benchmark, relative costs, tracking error and error and spreads, underlying liquidity, the number of market-makers and fund size and reputation. This happens in the initial stage when the ETF is chosen and then it’s continually reviewed over time as new products join the ETF universe.
“We regularly review and assess the marketplace to identify the best available options for our clients, but we are also mindful of not chopping and changing our selections frequently as this can trigger unnecessary cost and tax implications.”
Pro tip: The ASX produces a monthly report on investment products including ETFs that can be quite helpful in considering the investment landscape.
Going deeper into ETF selection
Dave recommends looking beyond historical performance when considering an ETF’s suitability for your investment portfolio.
“You need to have a considered reason for why you’re looking at a particular ETF. Past performance isn’t always a good guide to future performance and you should also understand the risks of the offering and the nature of what you’re buying,” he says.
Factors to consider include:
Issuers have to disclose the MER (management expense ratio) on each ETF. “It’s not a fee you get a bill for, but it’s borne by the ETF and it’ll be reflected in the price you pay,” Dave explains. In addition to the MER, ETFs are also required to separately disclose their net transactional and operational costs. These are the costs incurred by the funds for things like brokerage charges (for buying and selling the assets held by the ETF) and foreign exchange associated with the trading activities of the funds. “As these costs are paid out of the assets of the ETF, they will be ultimately reflected in the ETF’s price. These costs are typically buried in the ETF’s product disclosure statement, but it’s worth taking the time to hunt them out to really understand the overall cost position of the fund. Of course, an an ETF might not be the best for your purposes just because it’s the cheapest – it’s only one part of the analysis.”
It’s important to understand the assets you’ll be buying in an ETF and how liquid they are (that is, how easily can the ETF be quickly bought or sold at a price that closely reflects its intrinsic value). “That will influence performance as well as the risk,” Dave says. “For example, if you’re buying an emerging markets ETF, it’s important to understand what you are buying. Which country exposures are you buying and in what proportions. What currency risk are you taking on? As an example, emerging market equities has been a strong historical performer, but at the end of the day it is a more risky asset class with lots of currency and country risks. One of the reasons for this is that the markets where these ETFs have exposures will often be closed when you’re buying so that can affect the price as well as the risks.
“If you’re buying ASX200 stocks, they’re typically very liquid, so if you need to get out quickly, you still see pretty deep liquidity. But if you’re buying more esoteric exposures, it’s more difficult for the market makers to price those assets (as the underlying holdings in the ETF basket are less liquid) and that will be reflected in the prevailing prices and spreads. Less liquid assets don’t trade as often so the price you may be able to sell at may be quite different to the last traded price. ETFs are straightforward in some ways and complicated in others.”
Six Park’s preference is ETFs that are structured as “locally domiciled trusts”. This minimises the administrative burden on our clients who otherwise might have to file various overseas tax documents. Some ETFs also lend out their underlying securities to institutional investors who might be seeking to short sell a stock (i.e. borrow a stock to sell it in the hope of buying it back cheaper in the future). “Securities lending can modestly enhance an ETF’s return by bringing in extra fees, but it does introduce an element of additional risk which you need to be mindful of.”
TRACK RECORD OF THE ETF AND ITS ISSUER
Most of Australia’s ETF issuers are large and well established, have decent processes in place and have products that are commercially viable and acceptable. “If everything else was equal, we’d go with an issuer we knew that had a track record of running the ETF the way it should be run. We also prefer larger ETFs as a general rule because once a fund reaches critical mass, there is less risk of them increasing their fees to cover costs or potentially even closing down and returning investor funds.” Dave says. “But generally, the mainstream ETFs are large, and are run by a handful of professional well-known providers. It’s the selection process that’s hard.”
DIY versus Six Park
As you can see, it might be easy to choose an ETF – but it’s not easy to be confident you’re choosing the best ETFs.
“Could you do it yourself? Absolutely. But could you do it with the level of expertise that’s provided by our IAC and the data analysis being performed by the team and our optimiser?” Dave asks.
“From my perspective as both an analyst and a client, Six Park is providing multiple layers of service at a very low cost – first there’s the asset allocation expertise, then there’s ETF selection, then we monitor the investments and the assets and ensure portfolios are rebalanced and are staying true to the underlying investment strategy. It’s not impossible to do it yourself, but there’s a significant level of time and expertise involved in doing it well.”
Dave is happy to point out that he chooses to use Six Park to manage his family’s self-managed super fund, even though he has the capacity to do it himself. “It means I don’t have to think about it too often because I’m comfortable with the investment philosophy, with the way it’s being managed and by not having to do it myself I save time – it’s a no-brainer.”
Six Park researches the best ETFs available and can build your personalised portfolio based on your investment time frame and attitude and capacity for risk. To receive a personalised investment recommendation, click the “Get started” button below to take our free risk assessment.