In our last lesson we took a look at what an ETF is, and saw that ETFs can cover almost all asset classes like Shares, cash and commodities. The asset types that ETFs invest in is just one part of the story. The second part of the story is the investment management approach that the ETFs take. In the next few lessons we’ll take a look at the different investment management types that ETFs can follow, starting with the most popular of them all, index or passive ETFs.
Index ETFs are without a doubt the most popular ETF type and the ones that are responsible for the growth in popularity of ETFs as an investment vehicle.
To explain index ETFs, we must go back to our last lesson where we touched on managed funds. Traditionally, when you provide your pooled investments to a fund manager in a managed fund, the fund manager takes your money and attempts to use their expertise to outperform the general market. They then charge you a fee to use their expertise to attempt to outperform. This was the way managed funds operated for many years and an industry of highly paid investment analysts looking for the next asset to outperform now exists.
Index funds on the other hand don’t seek to outperform ‘the market’, they are happy to perform in line with the market, so buy ‘the market’. By doing this, they are able to sack all of their highly paid investment analysts and therefore reduce their fees. If different ETFs were flavours of icecream, passive ETFs are definitely vanilla!
When we talk about ‘the market’ above, this refers to the traditional benchmarks that apply. These benchmarks are market capitalisation based. This means the index is weighted based on the size of the companies (or other assets) in that particular market. This is best explained with an example:
Take for example the S&P/ASX 200 Index. This is the key Australian share market index and the one when news commentators say “the Australian share market went up 1.5% or down 30 points today” are likely referring to. The S&P/ASX 200 Index is essentially made up of the top 200 companies in Australia, ranked by the size of these companies. For example, if Commonwealth Bank is worth $100 billion, and the total share market size is $1 trillion ($1,000 Billion), Commonwealth Bank would then make up 10% (100/1,000) of the S&P/ASX 200 Index.
Of course the above example works great for shares, but for something like a commodity, an index tracking ETF would track the index that commodity tracks, which may be an exchange that the commodity trades on.
The low fees are just one of the benefits of passive or index ETFs. Proponents of these ETFs claim that the highly paid investment analysts that make active funds so expensive are playing a zero sum game, and over the long term their performance generally moves to the average. This means they provide only the return of the index but by charging higher fees, investors lose through lower returns.
There’s a whole movement of individuals who promote this index investing approach. The father of index investing is the founder of Vanguard Investments Jack Bogle, by creating the first index investment managed fund in 1975. His army of supporters label themselves ‘Bogleheads’.
Over half of the ETFs that trade on the ASX are index tracking and they account for more than 75% of ETFs by size.
Whilst there’s plenty of advantages of index tracking ETFs, the low fees and expected benchmark returns being the key advantages. They do have their disadvantages, for one, investors can expect to do no better than the benchmark. As a result, a number of other ETF types have been developed. In our next lesson we take a look at ‘Smart Beta’ ETFs.