Why ETFs are better than Funds

on Thursday, 27 November 2014. Posted in ,
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Exchange Trade Funds (ETFs) are now a core part of professional investors’ portfolios.  There are a number of good reasons for this and all point to these not-so-new products’ proven resilience and consistent returns. ETFs have turned into one of the most successful financial innovations of the last few decades owing to their flexibility, low costs and ease of access, quadrupling in size over the past ten years, from under half a billion US dollars in 2004 to managing assets worth $2.5 trillion in 2014, almost matching the Hedge Fund sector in record time. Currently there are 4,731 ETFs trading across the globe in a variety of sectors, offering different styles of investment strategies and risk exposure into what amounts to endless possibilities available to investors of all sizes.   But what are ETFs and how did we get here?

How it all began:

ETFs started life in Canada back in 1989, tracking the Toronto Stock Exchange (TSE) 35 and TSE 100 indexes, pooling capital from different investors, both big and small, in a manner similar to Mutual Funds but at a fraction of the cost, trading passively for fees amounting to just a few basis points. Indeed, “the Spider” (S&P 500 SPDR) America’s first, largest and most popular ETF dating back to 1993, has a expense ratio of just 0.09% while other ETFs cost 0.25% on average. This is in sharp contrast with traditionally managed funds that charge between 1% and 2% for their services. Since most Mutual Funds are unlikely to beat the market but for short periods of grace, it means that the far cheaper ETFs closely tracking their indexes produce better returns in the long run. As investors worldwide caught on these advantages, ETFs soon proved popular and New York’s “Spider” became the template for a growing number of products, spreading to Hong Kong in 1999, into Europe in 2000, Japan in 2001, and continued reaching out to new shores even as the dot-com bubble busted; since then almost every national burse has listed at least one ETF.

Are ETFs any different from Mutual Funds?

ETFs issue a number of shares representing investor’s participation in the fund instead of owning the indexed assets outright, much like mutual funds. ETFs however have a clear advantage in that their shares can be traded freely amongst investors at any point, while shares in a Mutual Fund can only change hands at the end of the business day through the fund’s manager. Since investors only trade in creation units, it does not matter how illiquid the underlying assets are for they will remain untouched, preventing any potentially damaging mismatches and liability to taxation for foreign investors since they never deal with the fund’s assets directly.

What happens if no one wants to buy the shares?

If no buyers can be found directly, the shares can be exchanged with the fund’s Authorised Participant (AP), usually an investment bank which takes the units back to the fund in exchange for underlying stocks, which it then returns to the market. ETFs typically employ the services of numerous APs to spread the risk, normally trading through clearing houses that stand behind the deal if the AP were to fail. All said, ETF investors rarely lack custom for their shares: it is estimated that only 9% and 19%, for equities and bonds respectively, require the creation/redemption of units, the rest is easily and freely traded in the open market.

How well have ETFs weathered recent crises?

Despite episodes of instability in the market, not only have ETFs proliferated across the world, but their assets keep growing in a solid upward trend. While the sector briefly stumbled under the ferocity of the market crash in 2008, assets quickly rebounded back to trend the following year, passing the first trillion mark even as the global economy still struggled. The panic of the Flash Crash in 2010 would prove a greater challenge as the funds’ accessible liquidity made them prime targets, yet as the market quickly corrected so did share prices for ETF investors who remained calm through storm. When rumours of impending tapering hit the markets with yet another bout of panic in 2013, ETFs proved even more resilient as most funds trading at only modest discounts from their respective NAVs before swiftly correcting, all while still attracting more and more capital to fuel their rise well beyond the 2 trillion mark.

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Source: the Economist1, October 25th

 

So, why ETFs are the most Safe and Efficient investment vehicles in the market?

As a recap from all previously discussed points, let us compare ETFs with traditionally managed Mutual Funds just to see why they really are the best product in offer and not just a fad:

EXCHANGE TRADED FUNDS

MUTUAL FUNDS

Pool capital from various investors regardless of size

Pool capital from various investors regardless of size

Participation through Shares/Units in the Fund

Participation through Shares/Units in the Fund

Most track their indexes passively

Usually actively traded

Returns in line with NAVs

Unlikely to beat the market in the long run

Charge 0.25% on Average

Costs between 1% to 2% on Average

Traded Freely

Traded through the Manager

Available throughout the day

Available at the end of the trading day only

More Liquid than its underlying assets

Rather illiquid due to limited availability

Risk spread through APs and Clearing Houses

Funds run all the risks

 

Clearly, not only are ETFs cheaper than your average Mutual Fund, they produce better returns in the long run since they never under-perform their benchmark and you pay little out of your earnings either to the Fund’s management or to the taxman. And you never have to worry about being locked into a failing position, your investments remain available all day long for you to dispose of them as you wish, while the Fund itself spreads its risks through various APs backed by Clearing Houses and collaterals.

 

While there are still some valid reasons to invest in traditional Funds or directly into securities, you should not ignore this fast growing sector and make ETFs a part, if not the core, of a more solid, diversified and safer investment portfolio.

 

 

 

About Caterer Goodman Partners
Caterer Goodman Partners is a Shanghai based wealth management firm established with a clear vision to provide a new level of personalized financial planning services for expatriates in Asia. Our financial advisors provide guidance for our clients in all areas of investment, specialising in managed accounts, money-market funds, retirement planning and alternative investments. At Caterer Goodman Partners, we offer our advice and experience to provide low cost, tax-effective and simple solutions to match our clients’ interests.

About Owen Caterer
Since graduation Mr Owen Caterer has worked with the Queensland Premier's Department in Trade Facilitation and then as a financial adviser in Shanghai from 2005 until 2010.  He then rose to Senior Adviser, then Business Development manager and then to Chief Investment Officer responsible for portfolios to a value of US$280 million across Asia. Following that Mr Caterer left to found his own firm with a partner in the financial advisory and wealth management area.   This focused on developing China and Asia's first fee-based financial advisory (rather than commission-based). This has grown to now have 8 staff and and managing almost US$35 million for clients throughout Asia. This business success was recognized as a finalist in the 2013 ACBA in the Start Up Enterprises category and are one of a small number of foreign managed firms to have a full asset management license in China.  Owen has also been active in the community volunteering for the Australian Chamber of Commerce in Shanghai and acting as the Vice-Chair of the Small Business Working Group (2012-2014) and as the Co-Deputy Chair of the Financial Services since 2013 until the present. They have continued to grow their business and have now been selected as a small group of companies who are platinum members of the Australian chamber of commerce. The achievement they are most proud of is their efforts to reform the financial planning industry in China and push it away from a hard-sales commission driven model to a more ethical management fee and long term customer service model.   Owen has a Graduate Diploma of Applied Finance from the Securities Institute of Australia of which he was a member as a Fellow of Finance for many years and also has an undergraduate degree from Griffith University in International Business.  Owen's interests are tennis, running and his wife and two children.  He speaks fluent Chinese, first arriving in China in 1997.
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