One of the longer-term effects of the global financial crisis has been the overall suppression of yields around the world. For yield investors in Australia, this squeeze on returns has been most evident in the slow downward spiral of rates on offer for cash accounts and term deposits, which have followed the Reserve Bank’s cash rate lower and lower.
In the light of this, it is hardly surprisingly that investors in Australia have started to cast around in the search for better returns than those they can secure from straightforward savings products. While this has led investors in a variety of different directions, one of the clear winners has been the exchange traded fund (ETF) space.
February 2015 was the biggest month so far for the ETF sector in Australia, showing net growth of $1bn in the month to reach $16.9bn while the sector saw growth of almost $2bn in the first two months of 2015. YieldReport analysis suggests that total funds under management in Australia in the cash and bond ETF sector reached $1.538bn in February with over half of that total, or $781m, invested in the solitary cash ETF in Australia from BetaShares.
What is in an ETF?
An ETF is an investment fund that holds a collection of investments, like bonds or term deposits, owned by investors but managed by a professional money management group. In this regards, ETFs are rather like managed funds, but unlike managed funds ETFs trade on the ASX in a similar way to company stocks. Investors will typically pay commissions and management fees to invest in ETFs and there may also be costs to set up an investment account. From an individual investor’s perspective, a generally positive feature of ETFs is that they can make it possible to build a fairly diversified portfolio with a relatively modest investment budget.
Important things that investors should know about ETFs
As indicated, ETFS trade like stocks. While this is a positive, buying and selling ETFs will mean the investor will have to pay a commission each time. As a result of this, it is wise for an investor to try to get a sense of the scale of trading fees when comparing ETFs with other forms of investment.
Investors in ETFs should also be aware of volatility. How volatile the performance of an ETF is will depend on the scope of the fund and so it is important to be aware of the fund’s focus and what types of investments it includes.
Liquidity of ETFs is also an important consideration. The more thinly traded an ETF is, the more problematic it could be to sell. Investors need to make sure that their choice of ETF is liquid by studying the spreads and the market movements over a period of time.
Capital gains implications. Some ETFs distribute capital gains to investors, which could lead to a capital gains tax burden. Some funds retain capital gains for reinvestment rather than distributing them and creating a tax liability for the investor. Well-managed ETFs will offer investors potential tax efficiencies.
How should investors choose an ETF?
The general rule of thumb is that investors should choose the lowest-cost ETF offered by the most capable provider. Investors in Australia are generally well served in this regards since all the ETFs providers are well-known and well-regarded. Investors need to do more than simply looking at ongoing management fee and will also have to consider looking at the bid-ask spread and whether or not the fund is trading at a discount/premium to the market.