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Since their inception in the 1990s, exchange-traded funds (ETFs) have become one of the most sought-after investment vehicles for individuals and institutions, globally. Offering diversification, trading, and arbitrage options, ETFs are often touted for their low cost and attractive profile, relative to mutual funds.
However, Morningstar Associate Director Justin Walsh reminds us that ETF trading does not come without its downfalls. He says the record net inflows observed last year should be considered with caution; and that a well-researched investment strategy remains crucial.
“It is hard not to get carried away with the momentum of this asset class, especially when both existing and newly-launched ETFs saw record net inflows last year,” said Justin ahead of the Inside ETFs Australia Conference, hosted by Informa Connect.
“By way of example, assets surged 23.9 percent to $117 billion in 2020; and $20.8 billion was pumped into local equity ETFs, marking a 12.1 percent year-on-year increase.
“That said, there are risks associated with the ETF market that can be overlooked amidst all the hype.”
Consider your investment horizon
Certain types of ETFs can offer lucrative rewards, but are subject to drastic price variations. For this reason, they may be better suited to investors with shorter term horizons, Justin suggests.
“We see globally the rise of Crypto ETFs and other speculative investments that have very high levels of volatility,” he said.
Similarly, more esoteric ETFs, such as those from narrowly-defined sectors – e.g. hydrogen, climate change related and precious metal funds – should be treated with caution.
“They tend to capture imagination early but don’t necessarily follow a long term upward trend. It’s important to tap into themes that will likely sustain investor interest over an extended period,” Justin said.
That said, ETFs that are diversified and from a well-selected index can be great for longer term players.
“Much like other investment vehicles, when you deviate from that and enter into an area that is much more concentrated, the rewards tend to be more transient,” Justin said.
Consider your risk appetite
While theme-based ETFs may offer a more attractive risk profile than cryptos, this attractiveness should not be overstated, Justin warns. Many theme-based ETFs are highly trend-driven, making them susceptible to sudden – and drastic – market movements.
“Trends can change abruptly, so if you are investing in a theme, consider whether it has a solid, fundamental base. If you can’t answer that question, then your doubt should be factored into the risk assessment,” Justin said.
As one key example, the electric vehicle market often sees significant fluctuations in investor appetite, reflected in the volatility of Tesla’s share price and related commodity prices.
On the plus side, ETFs tend to trade close to their net asset value (NAV), don’t ‘trap’ investors in the same way that listed investment companies (LICs) can, and do take into account offshore market moves, Justin argued.
“They aren’t perfect but they are have a superior capital structure with the role of market makers ensuring that many ETFs should trade close to their net asset value,” he said.
Home or away?
While domestic ETFs have performed well in recent years, the cumulative net flows into global equites were significantly greater, Justin highlights.
The ‘world large blend’, ‘North America’, and ‘world other’ categories were $2.2 billion higher than the net flows into the ‘Australian large-cap blend’ category.
European exposure also showed promise with last year’s net inflow into the equity Europe category surging to $347 million.
More accessible and secure than other investment vehicles
Despite their risks, ETFs have many advantages over other types of investment vehicle. Given their convenience, regulatory environment, and access to a large product set, it is easy to understand why ETF popularity has surged in recent years and is expected to continue its growth.
“ETFs are easy to buy and trade. By comparison, if you want to trade Bitcoin you need a certain amount of financial sophistication – it’s not something that everyone can grasp,” Justin said.
“Importantly, ETF trading is also protected by a solid legal structure, whereas Bitcoin is less regulated and has a high potential for fraud.
“In other words, there is a lot of appeal surrounding ETFs that doesn’t necessarily pertain to the reward side of things.”
More on ETFs
Reflecting on last years’ figures and looking towards upcoming developments for the ETF sector, Justin Walsh will present at the Inside ETFs Australia Conference, hosted by Informa Connect. This year’s event will be held 30 May at the Hilton Sydney. Learn more and register your place here.
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