Exchange-traded funds (ETFs) have exploded in popularity over the last few years.
The last couple of years, especially, has seen new all-time highs on a monthly basis for incoming flows for the Australian ETF industry.
September saw $2.9 billion added to local ETFs, according to BetaShares, which was yet another record.
“The industry ended September 2021 at a fresh all-time high of $125.3 billion total market cap, with total industry growth of $200m for the month,” said BetaShares co-founder Ilan Israelstam.
“Industry growth over the last 12 months has been 75.5%, for a total of $53.9 billion net growth over this period.”
Retail investors are favouring these products for the instant diversification, and sometimes active management, they provide.
There are now thematic ETFs that provide many different investment angles.
Some provide access to investments that are not readily available to the typical Australian retail investor, like overseas markets or unlisted assets.
The ASX on Thursday will even welcome its first-ever cryptocurrency themed ETF.
This is all fantastic. So why would any investor want to buy individual shares these days?
Nucleus Wealth spokesperson Jayden Stent had a go at explaining why Australians will still want to invest directly into shares.
Not all ETFs are passive
One potential trap is the volatility of some ETFs.
“You don’t want to be lulled into thinking that because some ETFs offer low volatility that all ETFs are the same,” Stent wrote on a Nucleus blog.
ETFs initially built up their reputation as index-followers that allow “passive” investing. But now there are so many thematic funds out there, that stereotype doesn’t necessarily hold.
“The potential for large swings will mainly depend on the type of the fund. For instance an ETF that tracks a specific industry such as oil or gas services,” said Stent.
“The viability of an ETF can be dependent on the economic and social stability of a particular country. Investors [need] to take note of what the ETF is tracking and what are the underlying risks associated with it.”
Expenses and liquidity
Investors need to be wary of the expenses charged by the ETF operator — something that you never have to encounter when buying shares directly.
“It’s important for investors to be aware that ETFs have what’s known as an expense ratio,” said Stent.
“This is a measure of what percentage of a fund’s total assets are required to cover various operating expenses each year. This has an effect on total returns — i.e. the higher the expense ratio, the lower the total returns will be for investors.”
Stent warned that liquidity is “one of the biggest detractors” for ETFs.
“That is, when you buy something, is there enough trading interest that you will be able to get out of it relatively quickly without moving the price?
“If an ETF is thinly traded there can be problems getting out of the investment, depending on the size of your investment in relation to the average trading volume.”
Control of your investments
The most obvious disadvantage of ETFs is the inability to pick and choose the companies invested.
“This means that an investor looking to avoid a particular company or industry for a reason — such as moral conflict — does not have the same level of control as an investor with direct individual share holdings.”
Because ETFs are a basket of different shares, tax treatment of capital gains and dividends can become complicated, as The Motley Fool has previously reported.
“Because different ETFs treat capital gains distributions in various ways, it can be a challenge for investors to have the control they need and would get from direct share holdings,” said Stent.