Personal finance editor Amanda Morrall talks to Pathfinder's John Berry about ETFs' how they work, the benefits, risks and what to watch for.

By Amanda Morrall

Exchange traded funds listed in the United States have grown in value to US$1.3 trillion, 25 times the size of the New Zealand stock exchange, worth NZ$50 billion.

They are popular for two main reasons: 1) fees; they're about half what you'd pay for a regular managed fund and 2) diversification; you can get a cross section of different assets when you buy into an ETF.

Charles Schwab, one of the issuers of ETFs in the U.S. last week, announced it was lowering the fees on some of its funds from 0.06% to 0.04%. Fees on managed funds vary greatly but gravitate around the 1% mark.

In New Zealand, ETF investors aren't so lucky. While the NZX operates an exchange traded fund called Smartshares, the size of the market here means that fees are higher. The range is between 0.60% and 0.75%.

While there is nothing stopping New Zealand investors from purchasing international ETFs, Berry said they run the risk of using a disreputable issuer, tax complications, and currency hedging problems.

He said the benefit of using a fund manager in New Zealand for ETF exposure abroad was threefold: 1) tax efficiencies 2) currency hedging expertise and 3) "frictionless brokerage."

New Zealand fund managers pay about 30 times less than a retail investor. Even so,  the New Zealand investor can expect to pay a premium for their services. For the skill and tax structuring, investment fees, while variable, push the investment costs up to around 1% or higher in many cases.

John Berry, director of Pathfinder Asset Management in Auckland, said fees on his boutique company's funds range from 1.17% to 1.30% exclusive of GST.

He said the higher fees here are a function of scale.

Pathfinder invests in 15-20 ETFs, the average cost of which is just under 20 basis points, so 0.2%.

Berry defines ETFs as a combination of a listed company and a normal unit trust fund.

"It's a combination because they are traded on the stock exchange so you can buy and sell them on a daily basis but they also have a feature where large investors and fund managers can go directly to the issuer and ask for units to be issued or redeemed.  So what that means is the price on the stock exchange should always equal the net asset value (NAV) of each share. So in the same way with a normal fund that you get it redeemed at the underlying value of the fund, with an ETF on the stock exchange it should trade at the underlying value of the assets in the fund."

As well as the low fee structure, diversification is a strong selling point.

Among ETFs in the U.S., about 70% is invested in equities strategies, 20% in bonds and fixed income, close to 10% in commodities and about 1% in currency and hedge fund ETFs.

In the U.S, more than 1,200 products are packaged in the form of ETFs. The NZX by comparison has about 167 listed stocks.

The three main providers of ETFs, BlackRock, Vanguard, and State Street, control about 80% of the market.

However, the evolution of the ETF market has seen a rapid increase in smaller issuers some of whom have constructed derivative based funds, those "unguided missiles" of the investment sphere.

In simple terms, derivatives are a contract between two parties where the underlying payment is linked to a security, .

Berry explains:

"So in the case of an ETF, it may enter a derivative contract with an investment bank, say over the S&P500. So if the S&P500 goes up the investment bank pays the ETF; and if the S&P500 goes down the ETF pays the investment bank. So there's no underlying securities held there.''

For investors, it poses a high 'credit risk.'

Pathfinder, for its part, has a policy only to invest in ETFs that have underlying shares and securities.

So why pay a fund manager when you can invest directly?

Basically for the sake of risk management, with currency hedging at the top of the list.

"When you are buying a U.S. listed security, it won't have hedging to the NZ dollar which has been very volatile. We've seen it move 10% in the last 10 months. Investors need to be aware of where the NZ dollar is going to head from here. They have to have a view on that or hedge the exposure.

"If you are investing in an ETF fund that has global exposure, it's not just the U.S. dollar that you'll be worried about. If the ETF holds European shares or Japanese shares, then it's the Yen and the Euro that you have to worry about. So be aware there are underlying currency exposures as well.''

Berry also cautions investors against using ETFs on the small end of the scale.

For example, Pathfinder won't use any ETFs valued at less than US$1 billion.

"The problem with the smaller ETFs is they can trade away from the net asset value so they are less liquid. If you go under US$1 billion or $500 million just be aware that they can trade away from the underlying value of the securities.''

Smart Index Strategies

A fairly recent development in ETFs is something call smart index strategies.

Berry describes them as the "next generation of index."

They differ from conventional exchange trade funds in that, "they have some intelligent rules built in there to either improve returns of reduce volatility,'' explains Berry.

"Dividend ETFs" are one such example.

"They don't just focus on the highest dividend paying stocks, they also have rules like the dividend has to have increased for the past 10 years,'' notes Berry.

Another such ETF recently launched by iShares, tries to buffer volatility by excluding from its basket those most volatile stocks on a particular index.

"So I might look at the S&P500 and take out the most volatile stocks that historically give the same returns but with a lot less volatility.''

As a result of this unique feature, smart index strategy modelled ETFs have weathered the global financial crisis and downturn better than many ETFs which simply mirrored the  market.

"With the smart index strategies, dividend stocks have done quite well because when risk is off people head to more conservative investments, utilities and dividends are things people look for. And minimum volatility have done quite well too because they don't have the volatility stocks in them.''

While Australia has seen a steady rise in exchange trade funds, the volume is still relatively low compared to North America.

There are around 80 listed exchange traded funds in Australia covering a range of different markets.

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