KEY POINTS:
Two weeks ago we looked at the claim, frequently made by active fund managers and their confederates, that actively managed funds outperform passively managed funds when markets are falling.
Research by Vanguard, the world's largest manager of passive funds, suggests that while some actively managed funds do indeed outperform in down markets, the number is less than half and you can't easily tell potential winners from losers.
Passively managed funds have had a real boost of late with the advent of exchange traded funds, or ETFs, as they are commonly known. ETFs and hedge funds are two of the most innovative financial products to emerge in the past two decades but they are at opposite ends of the fee spectrum.
Hedge funds charge high fees and search for alpha - outperformance of an index. Index funds generally have low fees and offer beta - the market return and nothing more.
Since the launch of the first ETF in the United States in 1993, ETFs have opened a panorama of investment opportunities offering exposure to all sorts of market niches. However, whether this ability to specialise is an opportunity or a threat to mum and dad's attempts at wealth creation is debatable.
Essentially ETFs are open-ended index funds that are listed and traded on exchanges like stocks. They allow investors to gain broad exposure to entire stock markets of different countries, emerging markets, sectors and styles as well as fixed-income and commodity indices with relative ease on a real-time basis and at a lower cost than many other forms of investing.
ETFs, unlike traditional funds, are transparent as the managers provide the ETF portfolio details to the market on a daily basis. ETFs are bought on a commission basis, just like any other share.
ETFs are as liquid as the underlying basket of securities and they are open-ended as opposed to closed-ended in that they have a unique creation and redemption process whereby stockbrokers buy the underlying stocks in the ETF portfolio and thereby create ETF units at a small profit to themselves.
The ability to continually create or redeem shares helps keep an ETF's market price in line with its underlying net asset value (NAV), unlike closed-end investment trusts where discounts and premiums occur.
According to research from Barclays Global Investors (BGI), there are currently 1767 ETFs with 3015 listings and assets of US$822.34 billion ($1.4 trillion) managed by 100 managers on 44 exchanges with 716 new products planned. Apparently it's all go in ETF land.
BGI, the world's largest ETF manager and a subsidiary of Barclays Bank in the UK, forecast that ETF assets under management would exceed US$1 trillion globally in 2009 and US$2 trillion in 2011. At the same time some pundits are saying that the hedge fund industry's assets under management will halve to US$1 trillion in the next 18 months. Maybe the fact that costs do matter is finally sinking in.
The proponents of exchange traded funds argue that one of their biggest advantages over traditional managed funds is that they are cheap to run with annual management fees as low as 0.05 per cent. This is certainly a modest fee. Indeed, many ETFs have even lower annual fee structures than the trailing fees commonly paid to financial advisers on traditional managed funds.
But that is not quite the end of the story because, despite their popularity overseas, local ETFs haven't caught on so widely. Even though we have a few local listings, to get set with a genuinely low-cost ETF investing in the world stock market, one needs to transact on the NYSE.
Even achieving a New Zealand equity exposure via an ETF is problematic. Most local ETFs have management expense ratios two to three times higher than the mainstream offerings overseas. Possibly as a consequence, many of the ETFs here are relatively illiquid in that turnover in each fund on the NZX is low.
The difference between ETFs here and on the NYSE could be institutional investors who appear to be actively trading the latter but are notably absent on the NZX. The high annual fees of the local ETF offerings are likely to be the reason.
The significance of this illiquidity is the wide bid/offer spread on many of our local ETFs, which means high trading costs for mum and dad. Last Saturday's Weekend Herald share page showed that, for example, the AMP Winz Fund was offered for sale at $1.06, but the best price at which brokers were prepared to buy it was $1.03. So if you bought at the offer and sold at the bid this would cost you 3 per cent before broker and exchange fees. Similarly the
SmartOZZY fund was offered at $2.60 but the best bid was $2.46.
ETFs regularly appear as the most widely traded stocks on the NYSE, therefore it is no surprise that the largest ETF on the NYSE, the S&P 500 SPDR Fund, has a typical spread of less than 0.5 per cent and some $2 billion worth of its shares trade each day. According to Deborah Fuhr, of Barclays Global Investors, the spread on the typical US ETF is usually a couple of cents - no big deal on the usual $40 to $50 share price. In contrast, back in New Zealand,
on Friday last week just $500 of the Smart TeNZ fund traded.
On some of the really bad days on the NZX in October the local ETF market all but dried up in some funds with virtually no stock for sale under a 3 per cent premium. An explanation may be that things got so volatile that basket creation of ETF units was deemed too risky by brokers.
Liquidity is thus a serious obstacle to investing in ETFs in this country. The NZX manages most of the locally listed ETFs and it is keen to encourage people to forget residential property and buy shares.
The NZX did not respond to emails requesting comment on the poor state of the local ETF market. For investors, both retail and institutional, the lack of a credible, low-cost passive alternative makes it actually cheaper to invest globally than at home. Not a very satisfactory state of affairs.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
