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ESSENTIALS

ETFs - Implementing Core & Satellite for SMSF & HNW Investors

www.LPAConline.com.au

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fund managers (“investing is too complex” – “leave it to the professionals” – “planners should spend less time thinking about investing and more time cultivating new and existing clients to build a profitable business” etc etc) is ultimately destined to fail in their pursuit of a large and profitable business with quality clients and recurring revenues. The market is moving too quickly, and retail clients are becoming too well informed, to hide behind these orthodoxies any longer.

What we have seen over the last 5 years is the rapid recognition by many quality advisers that they have to re-think the way they do business, and that this extends to the investment portfolio and its construction. At the same time, for lots of reasons (some good, some less so) the mantra of “scalability” is still a key concept for advisers – and in the era of modern business systems, it does seem sensible to ensure that the investment process is scaleable and efficient to administer.

In this Special Edition of ESSENTIALS we focus on the tools that progressive advisers are implementing in their practices: the use of a “core and satellite” approach to investing – and within that core, increasingly advisers are using Exchange Traded Funds to generate low cost beta, as well as to enhance the efficiency of the planner’s practice. The data showing the relevance of ETFs as beta generators just keeps on improving. The analysis in these pages shows just why it is that low cost ETFs are becoming an important part of the global investment landscape.

The core and satellite approach offers several benefits. Clients can get real focus on alpha generation, at the same time as keeping their beta generators running efficiently. The core and satellite approach allows advisers to implement the latest buzz word in investment management – by rotating between alpha generators, clients can benefit from DIY “portable alpha” in their portfolios. This means that the core of the portfolio can remain relatively unchanged for lengthy periods – with the risk budget, as well as the advisers time and management budget – being diverted to what the client will really value them for – the generation of outperformance. This meets the test of scaleability, and once you have made the transition, seems to be easy for many of our planning clients to implement without significant change to the way their business runs.

2009 has closed with a sense of vibrancy for many, with quality advisers around the country rolling out a sophisticated value proposition to their client base. If you haven’t already done so, now is the time to think about how you can re-boot your practice and your clients’ portfolios. Core and satellite investing will be part of that approach; but don’t forget that if you are going to the trouble to change the way you do business, tell your clients what the benefits for them will be. As to those benefits, we are sure that you will find a few in the pages of this Special Edition of ESSENTIALS.

Tony Rumble, PhD,Founder, LPAC Online Pty Ltd Founder, Alpha Structured Investments Pty Ltd.

www.LPAConline.com.auwww.twitter.com/TonyRumble

editorial

Like all of you, after the stress of the GFC this Christmas will be a great chance to relax and forget the cares of the financial planning industry, even if just for a short time. Whether you are planning to spend the break on the beach, watching sport, or just relaxing – we wish you a very merry Christmas and very happy and prosperous New Year.

Prosperity is what your clients pay you to help them achieve. This doesn’t have to mean an endless (and maybe pointless) search for the “best” investments. The thousands of planners that have participated in our LPAC training since we began in 2003 have understood that there are three big trends afoot in financial planning:1. Many progressive advisers have learnt how to offer

a credible SMSF program to their suitable clients, often within a “fee for service” offering;

2. There is an almost total overlap between SMSF equipped advisers and those that also provide direct equities advice to their clients (many of these advisers include direct equities as part of a portfolio including the best performing managed funds – the latter ideal for sectors that direct equities don’t provide an easy solution for, eg international, small cap, specific styles etc);

3. Those same advisers tend to a judicious use of structured products eg ASX listed instalments over the same shares that have been selected for direct investing, hybrid securities for the enhanced fixed income component, and maybe 100% protected investments for accumulators.

ETF’s are increasingly being used as part of the “core” of the investment portfolio, with direct equities and structured products sitting neatly in the “satellite” component. In this Special Edition of “Essentials” we focus on how to optimize the “core and satellite” approach, to deliver powerful benefits to clients and to your practice.

In 2009 we celebrated another milestone in our LPAC program. We have now enrolled and delivered LPAC training to a couple of 1000 of the country’s best financial planners. This year we were successful in achieving our own “Registered Training Organisation” status, we now deliver top level training and accreditation on a range of specialized investments and strategies. It’s all part of keeping us, and you, at the forefront of the financial planning industry.

This year the media feasted on the numerous regulatory reviews of the financial planning industry. What we didn’t see, unfortunately, was any reasoned response from the progressive end of the planning industry or the fund managers that were the subject of the report. This is troubling, because as the many, many well trained and professional financial advisers that are thinking ahead of the curve know – keeping your clients happy and comfortable now includes attending to the performance of the investment portfolio. And in this regard, a good financial planner will be very well equipped to deliver exactly what their client’s want, and need.

Any adviser that succumbs to the mantra of the large

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EXCHANGE TRADED FUNDS:

IMPLEMENTING CORE AND SATELLITE INVESTING FOR SMSF AND HNW CLIENTS

Core and satellite portfolio construction has to be thought of as more than just another way to blend

traditional managed funds. It reflects the very different style of investing to achieve general market returns (“beta”) compared to investing to generate

outperformance above the general market (“alpha”). Because of these differences, it is vital to separate the equity portfolio into two components, differently managed to align with the very different objectives of each component. In doing so, not only are the overall

portfolio returns capable of being enhanced, tax efficiency and risk management are improved. Financial

planners adopting the “core and satellite” approach provide a strong and differentiated service proposition

to their clients, ideally suited to SMSF and HNW clients. Index tracking “exchange traded funds” are ideal for the core portfolio, and low turnover “concentrated” direct equity portfolios (or managed funds that adopt

this approach) are ideal for the satellite portfolio.

I. Core and Satellite – The Essentials

As investors and advisers become more discerning, investment managers are expanding the range of investments available to allow investors and advisers to tailor portfolios to suit individual needs. One of the emerging trends in this field is the use of different products to generate investment “beta” (ie the general market performance) and “alpha” (ie the out performance over that of the market “beta”). This is easily implemented in a “core and satellite” approach:

One of the most promising investment models is “core and tactical satellite.” This model allocates a significant portion of the equity investment to a passive tax-managed core (possibly with style or class tilt). The balance of the allocation is made to satellite (investments). These satellite(s)… may be given broad mandates and the strategy may incorporate tactical changes in satellite(s). The total portfolio is managed to be dynamically efficient in a taxable client’s three-dimensional investment space (return, risk and taxes). This may become the basic wealth manager investment model for the future.1

Since the Australian launch of index tracking ETF’s (and index funds) earlier this decade, index proponents have made a valuable contribution to the debate about portfolio construction using the “core and satellite” approach. Index proponents typically describe the wave of data showing the statistical underperformance of most active fund managers compared to their index benchmarks. That data is not new, and indeed it’s been reinforced by the landmark APRA paper released in June 2009 – which makes some very harsh statements regarding typical managed fund underperformance.

Index proponents typically pitch their message to the cost conscious investor – pointing out that ETF’s and index funds are a low cost way to obtain the general market return or “beta” that is all that many expensive managed funds deliver.

But to really power our understanding of the core and satellite approach we need to reflect on a key point - why typical managed funds underperform – which is central to understanding the real value of using a long term, “buy and hold” approach to direct share ownership as part of well constructed portfolios.

Until the June 2009 APRA paper, the most accurate performance appraisal of traditional Australian actively managed equity funds has been produced using data provided by Mercer’s.2 This research shows that the median Australian active equity fund has underperformed its benchmark in 10 of the last 15 years.

Figure 1:Performance Appraisal – Australian Active Equity Funds 1991 to 2005

In Figure 1, the benchmark is the ASX 200 index plus 2%, (which is the median cost of investing in the surveyed funds, via retail or wholesale via wrap or master trust).

The irony is that these findings are not new. Asset consultants like Intech have been making similar statements for the last decade. The newly launched S&P “SPIVA” Index shows the same persistent underperformance by the majority of traditional managed funds.

Mainstream financial planners and dealer groups, for whom the managed fund/model portfolio/wrap platform model is the basis of their business, typically counter this critique by asserting that their manager selection processes are superior and that they avoid the median performing manager/s.

Many clients question that approach when it is noted that manager performance persistence is weak – the Mercer research also shows that managers which perform above the median don’t consistently do so – nearly 2/3 of the outperformers are back below the median within 3 years.

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And so, supported by hard evidence and client demand, progressive advisers are looking for a better way to manage their client investments – and the core + satellite approach has rapidly become the norm for these advisers.

APRA has weighed into the debate with its recent paper “Investment performance ranking of superannuation firms.3 The methodology used by APRA is set out in that paper, which leads its authors to make statements like the following, which coincide in many respects with the earlier findings of Mercer, InTech, et al:

“… the average (investment management) firm under-performed their net benchmark by 0.9% per year… this raises a question about the value of the active approach to risk management of investment portfolios and may support our doubt about the appropriateness of the Sharpe ratio in measuring performance …

The net under-performance of the average firm appears more pronounced in down markets. This suggests either inactive risk management where investment managers appear to forego value adding opportunities in down markets or unsuccessful risk management in down markets perhaps due to costs …

The empirical data suggests that superannuation firms may be less efficient at using the tax credits from capital gains and losses than we have assumed… For example, excessive share trading could forfeit capital gains tax concessions, which are available after a 12 month holding period.” 4

As we enter the 2nd decade of the new millennium, the investment revolution has now passed on from the “active vs index” debate: discerning investors and advisers realize that the real game is all about using concentrated portfolios of direct equities to generate long term wealth for retirement. That’s the best way to generate alpha: and by learning more about the essentials of alpha generation, we can also properly evaluate the use of index tracking ETF’s as the most efficient way to generate consistent, low cost beta.

II. How do we implement a core and satellite approach?

Portfolios modeled on the core and satellite approach tend to include the following:

• Ascoreinvestments,listedorunlistedpassiveorbenchmark aware investments including ETF’s.

• Aseithercoreorsatelliteinvestments(dependingon the client’s risk tolerance and portfolio size), boutique funds often offering an absolute return style and also specialist funds offering opportunistic approaches to alpha generation.

• Assatellites,concentratedportfoliosofdirectequities with low turnover and deliberately benchmark unaware mandates, and selectively used structured investments with alpha generating underlying assets and some level of capital protection to assist in managing downside risk.

Modern Portfolio Theory assumes that investment markets are efficient and investor behavior is rational. The GFC is the final nail in the coffin of these key notions of modern portfolio theory – based on the ideals of MPT, traditional portfolio construction has been based on taking a long-term view, accepting that markets rise and fall in the short term and that diversifying across a range of asset classes and investment types will provide an overall smoothing of returns. However, as many investors are only too painfully aware, portfolios built with faithful attention to the ideals of MPT often disappoint, particularly in relation to certainty of returns.

The core and satellite approach to portfolio construction does not ignore traditional approaches. Instead it focuses on matching the portfolio to the client’s true tolerance to investment risk and volatility. Research shows that over 2/3 of Australian investors are benchmark unaware, focusing instead on the absolute return of their portfolio. In fact, the traditional focus by fund managers and consultants on “risk” and “return” is a gross oversimplification. Most advisers now see clients who focus on the value added by each

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part of the supply chain (eg. adviser, fund manager, platform and dealer group) and specifically clients who question:

• Fees,attheleveloftheadviser,productprovider,platform and dealer group

• Taxestriggeredbytheoverallportfolioandindividualinvestments

• Liquidity

• Riskmanagement

• Thelikelyorexpectedreturnofeachinvestment

• Thepotentialforexcessreturnfromeachinvestment

Figure 2 shows the six dimensions of portfolio construction, comparing a traditional blend of active equity managers (eg. one value, one growth). The dotted line represents the State Street SPDR ETF over the ASX 200. In this figure, a good rating on any particular axis is represented by a mark further away from the centre – a superior investment has a very large surface area and a poor investment has a small surface area. Four things are immediately evident:

• Intermsoffeesandtaxes,theETFismoreefficientthan the active funds;

• TheETFallowsformorepreciseriskcontrolthantheactive funds;

• BoththeETFandtheactivefundsprovidesimilarliquidity and expected return (beta); and

• Theactivefundsprovidethepotentialforexcessreturns (alpha).

Using the core and satellite approach with ETF’s generating beta allows for less desirable attributes (eg fees, underperformance) to be traded off for more important attributes – specifically tailored to suit individual clients needs.

Figure 2: Six dimensions of portfolio construction for an Australian equities portfolio

For example, by using the ETF as the core beta generator for an Australian equity portfolio, we can avoid worrying about whether the core portfolio will be able to generate excess returns – because alpha generation is now the job of the satellite investments. In addition, the ETF provides superior performance on other key attributes, such as fees and taxes.

A number of studies have shown the high effective cost of taxes on traditional, active equity funds, which typically are characterized by very high turnover. For example, Credaro suggests that a high turnover fund (60% or more of the assets turned over every 12 months) needs to produce a return which is 1.6% higher than a fund with 20% turnover, just to break even. Since the turnover in a well run ETF is as low as 10% per annum, so ETF’s can deliver a far superior tax outcome than high turnover, actively managed funds.

And since the median actively managed fund struggles consistently to add any alpha at all, the case for inclusion of the ETF as part of the portfolio is well made.

III. What causes actively managed funds to underperform?

Actively managed funds, delivered using the unit trust structure, have proliferated since the 1983 financial services de-regulation ushered in by the Campbell Committee. Prior to that de-regulation the dominant form of externally managed investments were provided either by Listed Investment Company’s (“LIC’s”) or by insurance products. Both forms of investment suffered from inherent problems, which limited their access by many investors.

Traditional LIC’s have a solid and well deserved track record, with many of the early LIC’s posting long periods of profits and returns well in excess of those of the general market. Traditional LIC’s are closed ended and can invest in concentrated equity portfolios with low turnover – they don’t have to manage with an eye to the high levels of daily liquidity which open ended managed funds are focused on. But the drawback of the closed ended LIC is that the better performers often trade above net asset value. When a LIC trades at a premium to its fair value, it’s harder to justify investing. This has a spill-over effect, beyond the limitations for DIY investors, in that it makes it difficult for the financial planning industry to build a useful business model around LIC’s.

Insurance contracts were the dominant form of collective investment vehicle prior to the Campbell Committee reforms. Since insurance (appropriately) is regulated by detailed prudential and reserving requirements, this meant that “normal” investors were burdened by regulation, which was not necessarily relevant or suitable for them. The Campbell Committee recommended that simpler and better targeted

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investment funds should be available, without elaborate reserving and prudential requirements. This ushered in what we now refer to as the “traditional” managed fund industry.

Under the general funds management regulatory regime, non insurance products do not have the same prudential requirements as insurance products or banks (both of which rely on various forms of “reserving” to ensure investor protection) and, to be able to offer them in scalable, open ended format, their design needs to be aware of the potential for investor loss in the event of a “run” on the fund.

The traditional unit trust registry does not provide fund managers with details regarding individual investor’s expected investment timeframes, so coupled with the open ended nature of these funds, manager’s have to cater for the prospect that in times of financial distress, the level of redemptions in the fund will rise dramatically.

As a result, traditional open ended equity managed funds tend to invest in the most liquid equity securities available to them; in the case of Australia this is the ASX 200 index. To justify their existence and fees, most managers attempt to beat the index by being slightly under or over weight specific stocks in that index (this is recognized in the APRA paper which states that “… investment managers are hired to exploit market inefficiencies to add incremental returns through market timing or tactical asset allocation and through selecting or over-weighting better-performing securities, while trying to minimize trading costs”).5

Benchmark awareness means, in practice, that these types of funds will sell stocks when the market falls and re-purchase stocks when the market rises (in line with general market movements, adjusted as desired to allow for over - or under-weighting of specific stocks).

This leads to the high turnover experienced by traditional managed funds, which is reported in many cases as being as high as 60% to 80% turnover per annum. The inherent and inescapable problem with high turnover is that it exposes the investment portfolio to high and uncontrollable volatility. As Figure 3 below shows, volatility is extremely high when shares are bought and sold within a 12 month period, but it tapers off as shares are held for a longer period.

SMSF investor and advisers are implicitly posing the question: why would an investment style rely on high levels of turnover when the underlying investor has a long-term investment time frame?

On proper reflection, it can be seen that this type of investment management is typically unnecessary, unless the investor has a high probability of needing to access their capital within a very short timeframe.

Figure 3: Volatility (dispersal of returns) for Australian shares over timeSource: ASX Limited

The fallacy in the approach of traditional managed funds – and the singular cause of the high turnover associated with the benchmark aware style - is that it assumes that every investor needs daily liquidity. Driven by the limitations of anachronistic registry and platform technology, traditional funds are managed to provide maximum liquidity for all investors, at all times (even when not needed). Clearly, an investor in the wealth accumulation phase, especially within the superannuation environment (where funds cannot be withdrawn without penalty prior to age 60) does not need the same levels of liquidity as an investor in late pension phase.

Although not many SMSF investors or advisers articulate the technical investment rationale for SMSF’s, they do know what they hope to achieve when using the SMSF approach. Investment control is cited as the top factor driving the use of SMSF’s – and an increasingly large number of SMSF investor’s shun managed funds and use, instead, concentrated portfolios of direct equities (often, to good result).

In summary, we have shown how the idea of index benchmarked, high turnover actively managed funds is a creature of the combined benefits of de-regulation (allowing for non reserve protected investment funds) and limitations of the open ended unit trust vehicle and the anachronistic unit trust registry software. It’s no wonder that the SMSF revolution has ushered in a new focus on precise tailoring of portfolios to suit the specific needs of individual investors. The core and satellite approach is the best way to implement this precision and control.

IV. Using concentrated, low turnover direct equity portfolios to generate investment “alpha”

Understanding the true use of equities to generate wealth is one of the hardest, yet most basic, concepts in investing. It requires an appreciation of the equity risk premium and its near relative, the concept of the

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“payback” period. When these concepts are understood it becomes apparent that buying shares can be seen a lot like how a landlord buys and holds investment properties as a source of growing yield – and where capital appreciation is normally a secondary factor.

One of my favourite articles was written by Arun Abey in 2003 and its opening sentence is still relevant today: “Few things in this bear market have caused more confusion than the equity risk premium, and the research community itself is split three ways.” The article gives us a very clear message about why we should buy shares, even when they are trading at depressed prices:

In a market based society, wealth is generated through the company structure. Apart from building your own business, owning shares is the only meaningful way to participate in the long term growth in companies and the economy.... in a market based society, companies that are expected to produce lower returns than risk free bank deposits eventually fail...Only quality companies survive for the very long term ...

Because this “creative destruction” directs funds to companies that make money, investors can be pretty sure that an equity risk premium will be there over the very long term in a successful market based society ...

Over the average investor’s lifetime, the equity risk premium will almost certainly be there and should be generous. Only those who invest in equities consistently will capture the full reward with any reliability.6

Shares should be treated like investment properties – yield first, capital growth second.

When I deliver training to planners we have the opportunity to reflect on successful property investors – most of us know landlords who are living off the rent of properties purchased many years ago. It’s the same for shares – the yield on NAB shares purchased in 1990 is, in today’s terms, approaching 50% pa based on the initial cost of those shares. There is nothing more certain than the gratitude a client will show you for setting them up with assets that yield them these levels in their retirement. Even if dividends are under pressure in the near term, they can and will grow over time (for quality stocks that is, remember that we do advocate some level of active management so that you can get rid of bad performers over time).

In Figures 4 and 5 we show how buying investment properties for the long term generation of strong yield – based on the initial investment cost – is very similar to the returns from a long term, “buy and hold” approach to share investing.

In Figure 4, the patient landlord enjoys access to a steadily growing stream of rental income, with the yield on the original investment cost rising above 50%

after 30 years. Even though the capital value of the investment fluctuates over that period, the investor is practically insulated from that volatility because they don’t need (or want) to sell the property during that period. Of course, as the investor enters pension phase they may need to sell the property to meet lifestyle requirements; in the best case they can afford to live off the earnings instead.

Figure 4: The wealth creation effect of investment properties

In Figure 5 we show the same phenomenon as it applies to shares. In this case we use the real example of NAB, with the yield as a function of the initial investment price having risen to well above 50% in less than 20 years. Of course, we advocate a diversified share portfolio, the single stock example is used simply to illustrate the long term wealth creation opportunities using the patient “buy and hold” approach.

The Landlord Effect can be expressed another way. It is simply a product of the excess return above the risk free rate, which quality shares normally generate. For example, if a share is valued at a price/earnings ratio of (say) 13 times, this implies that if the company’s earnings remain constant, the share will pay for itself after 13 years. That means that the investor’s initial capital outlay will be recouped after 13 years – such that further earnings are pure profit to the investor.

Figure 5: The wealth creation effect of share investing

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This profit is the equity risk premium at work – the investor is compensated for taking the risk of buying the share in the first place by the payback period covering the initial cost of outlay. And since the earnings on quality shares typically rise over time, the payback period is normally (and ought be) faster than implied by current year P/E multiples.

In contrast, buying and selling the same shares frequently exposes the investor to paying potentially a higher price for shares every time they buy them. On that approach, the Landlord Effect can never be allowed to work for high turnover share investors. Every time the share is bought, the higher price drags the yield back. It’s no wonder that high turnover managed funds don’t provide the same retirement benefits that low turnover direct equity portfolios can deliver.

V. Putting it all together

That’s why the “core and satellite” approach is so conducive to long term wealth creation. The core of the portfolio should access the general market return or “beta” for the lowest available cost. Index funds or ETF’s like the StateStreet SPDRS with fees as low as 0.286% pa are the best way to generate market beta. Unless you are an investor that has a need for maximum levels of liquidity (in which case the traditional managed fund may be ideal for your needs), the optimal way to generate market alpha is to invest in concentrated share portfolios and to hold these as satellites around the core of index tracking investments.

Structured products can be used to optimize the risk/return profile of both the core as well as the satellite components of the portfolio. In more mature markets like the US, structured products are a mainstream part

of the investment portfolio, especially for HNW investors.

If you don’t have the time or inclination to select shares yourself, you can use the services of a fund manager that uses this approach, or invest in an SMA that runs portfolios selected by leading research providers (the best “model portfolio” has beaten the index by 9% on average every year since inception in 2001).

Using the buy and hold approach to direct share investing allows investors to access the proven potential for well managed companies to produce growing streams of earnings, which should be re-invested in accumulation phase and which can be used to fund lifestyle and expenses in retirement. The capital value of the shares will rise over time, as well – but by avoiding the high turnover associated with traditional managed funds, investors can avoid the high volatility and potential for needless capital erosion which is the major cause for the under-performance exhibited by most traditional managed funds.

Tony Rumble, PhDFounder, LPAC Online Pty Ltd and Alpha Structured Investments Pty Ltd, AFSL 290054

Footnotes:1. Evensky H: “Changing Equity Premium Implications for Wealth Management Portfolio Design and Implementation” in US Journal of Financial Planning June 2002)2. It is acknowledged that the APRA paper analyses the performance of balanced funds, not the norm for use by financial advisers that recommend funds for specific asset classes or sectors. However, the APRA findings are consistent with the earlier work of SSgA et al.3. Sy W and Liu K: “Investment performance ranking of superannuation firms” (APRA Working Paper, 23 June 2009).4. Ibid, p. 18, emphasis added.5. Ibid, p.10.6. Abey A, IFA, March 2003.

SMSF STRATEGY: USING ETFs FOR TAX EFFECTIVE INVESTING

When we think about investments, one of the key approaches being used by progressive advisers is to assess the “Six Benefits” of the investment as it sits in the overall portfolio. As Figure 4 shows, we can often find investments that provide exposure to an asset class but in different ways, eg there will be differences in fees, taxes, risk etc between many investments. Judicious combination of investments allows the adviser and the client to tilt the portfolio in specific directions, or to control the performance of the portfolio as it is impacted by each of these factors.

In the modern age of financial planning, fees and taxes are of paramount importance. Both erode the compounded returns of the investment portfolio and require significant additional investment returns to compensate investors. Studies by groups such as Macquarie Funds Management have estimated that

0.50% per annum excess return is required to offset the impact of taxes in super generated by highly active fund managers, when measured over a 25 year period. Clearly, many fund managers don’t generate this type of excess return – and thus put in a nutshell, taxes and fees are destroying the long term future for millions of Australians.

Lets recall why active funds pay taxes. First, the “genius” of the Hawke/Keating Government, (which introduced tax on super in its early wave of tax reform) was the recognition that super represented a massive and hitherto unplucked golden goose. Even though the imputation system was seen as an offset to tax on super, the negative impact on retiree savings from the various super taxes introduced by Labor is profound. Super taxes include both contributions tax (at the rate of 15%) and earnings tax (15% on fund gains, levied annually).

Imputation credits offset super taxes, as does discount CGT. The problem is that the common choice of wrapper for many investors – ie the unlisted, pooled unit trust – involves the trustee paying tax. In high turnover funds this means that the tax bill from intra - year buying and selling erodes the benefit of imputation received from

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Aussie shares, and positions traded within 12 months lose the availability of discount CGT as well.

In answer to these concerns, many investors are now turning to the use of a component of direct equities, which are re-balanced on a relatively infrequent basis; this approach reduces the incidence of tax as well as lowering the cost of running the portfolio. In addition, the core and satellite approach is now being used to separate low cost beta generation from potentially higher cost alpha generators. Putting this all together, we can see that one of the best ways to boost returns is to defer realization of income or gains until the investor has entered the pension phase. When the investor moves to the pension phase, income and gains on assets sold to support the payment of the pension are free of tax.

Which brings us back to the problem with traditional high turnover active equity funds. What drives the turnover in these funds is the attempt by the manager to “hug” the underlying index. High levels of turnover drive the tax bill higher, and as outlined above, this adds up to an additional 0.5% pa to the excess return needed to cover tax costs. In many cases, these excess returns aren’t delivered. A smart alternative uses the tax efficiency of the ETF as a way to generate market beta but with greatly improved tax outcomes.

ETFs don’t actively trade shares to track an index. They

simply hold the shares that are within the index, and as the index value rises and falls, so too does the value of the ETF. Of course, when the index is reset by its providers (which happens relatively infrequently, eg News Corp was rejected from the ASX 200 when it changed its domicile to the US), so too will this trigger a trade within the ETF. But apart from that situation, ETFs are comparatively low turnover ways to generate tax effective alpha. The simple logic for super fund investors looks to use the ETF as part of the core of the portfolio, to keep that exposure intact until the client moves into pension phase, and only at that time to consider realizing some of the embedded gains in the ETF – at that time benefiting from the tax freedom within the pension regime.

To really turbo charge this strategy, consider gearing the ETF, either in an Instalment structure (eligible for use in SMSF) or in the client’s own name. In the latter case, if the client is an “eligible unsupported person” (ITAA 1936 S82AAT, 82AAS (2) & (3)) the client can:

• BuytheETFintheirownname;

• Makeanin-speciesupercontributionoftheETFtoSMSF up to MDC (this provides a tax deduction for client;

• CGTliability(triggeredbyin-speciesupercontribution) is offset by personal tax deduction.

WHAT ARE EXCHANGE TRADED FUNDS?

Exchange Traded Funds (ETFs) are, as the name suggests, collective investment vehicles, which are listed and traded on a stock exchange. In the case of Australian ETFs the ASX provides a platform for the listing of a range of ETFs, covering both Australian and international markets. ETFs are designed to invest in a wide range of securities, which may include Australian shares, international shares, fixed income securities, listed property trusts, or a combination of asset classes.

Most ETFs invest in shares, and the simplest example are ETFs which hold shares in broad market indices or sectors, such as the ASX/S&P 200. The MER for ETFs is lower than most unlisted managed funds, ranging in Australia between 0.28% pa to 1.0% pa. As a result, ETFs provide simple and cost effective means of establishing the foundation of a diversified portfolio, and are suitable as the core of a portfolio, which can then include further “satellite” investments which can both spread risk and enhance potential return for the investor.

ASX listing provides greater potential liquidity for investors than unlisted managed funds (but of course the specific liquidity of ETFs vs unlisted funds should be reviewed carefully before actual investments are made), and cash proceeds from sales are available in the usual T+3 ASX settlement cycle. Like most other managed funds, most ETFs are eligible for margin loans, and also have a range of structured products which are now being created around them.Typical ETFs pass through all dividends and associated franking credits to investors, with management fees being deducted from the dividend income (or in some cases from the capital value of the assets in the ETF).

ETFs deploy a range of strategies to ensure the price of units in the ETF closely tracks the NTA of the ETF. The two main methods are described below.

How ETFs are valued

As open ended funds, all ETFs feature a continuous primary market for ongoing unit creation and redemption operating simultaneously with a secondary market that is traded on an exchange.

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Net Asset Value and Traded Price

Each ETF has two values:

The net asset value (NAV) of the units. This is derived with reference to the value of the underlying portfolio of securities and/or other assets that the fund has invested in on the unit holders’ behalf. For an ETF that invests in shares or other liquid securities, the net asset value will typically be established once a day after market close.

The unit’s traded price, which is determined by the bids, offers and sales that occur on ASX’s market. The unit’s traded price is the last traded price throughout ASX’s trading day, as is the case with all other securities that trade on ASX’s equities market.

One of the principal objectives of any ETF is to keep the unit NAV and traded price tracking very closely to one another. All ETFs rely on changing the quantity of units available for trading on ASX’s market as a means of achieving this outcome. There are two approaches that are used to achieve this objective.

Arbitrage

Classical ETFs rely on arbitrage between the primary and secondary market to achieve balance between supply of and demand for units on the secondary market and hence deliver a traded price that tracks closely to net asset value. This is achieved by changing the quantity of units on issue. “In kind” unit creation and redemption is the mechanism through which the quantity of units on issue can change. For classical ETFs, discounts or premiums between the traded unit price and underlying net asset value cannot generally be sustained, as a large investor will typically move to create or redeem units to take advantage of any price discrepancy.

Whilst classical ETFs may have a designated market maker, the ability to influence the number of units on issue through ordering a unit creation or redemption is generally open to any market participant that has, or is able to assemble the portfolio of shares that is required for a unit creation, or the number of ETF units that is required for a unit redemption.

Market Making

Hybrid ETFs will typically rely on market making to maintaining parity between the unit NAV and traded price. A broker is appointed by the issuer as the ‘market maker’ to the fund.

The market maker is responsible for providing liquidity to ensure that units trade at fair value. Typically, the market maker presents both buy and sell orders in the market, which closely reflect the fund’s NAV. The market maker typically gives an undertaking to manage the spread between bids and offers, to ensure that investors obtain a

fair price to net asset value when buying or selling units in these ETFs.

This approach is not unique to ETFs. It is currently used in ASX’s Warrants Market.

Implications for Investors

What do these approaches mean in practice? Classical ETFs generally don’t accept cash applications for unit creations and redemptions. Only large investors that are able to assemble the portfolio of stocks or minimum number of ETF units will be able to apply directly to the issuer to create and redeem units in classical ETFs. Investors who are interested in buying and selling units in these ETFs can do so via the ASX.

Hybrid ETFs that rely on the market making approach are typically open for cash applications from small investors as well offering the ability to buy and sell for cash on ASX.

Investment in ETFs is usually through a stockbroker (for retail investors) and through the ETF manager itself (for larger orders).

Unlike LICs, ETFs are open-ended funds, as a result of the mechanics of buying and selling ETF units. As investors move in and out of ETFs, the ETF manager will issue or cancel units, ensuring that ETF prices do not trade at a premium or discount to fair value as a result of supply and demand.

As indicated above, there are two main types of ETFs, the classical structure, or the newer type, which is known as a hybrid. Classical ETFs are normally based on an index or defined asset sector, and allow for instant portfolio exposure to that index or sector. These classical ETFs physically buy the constituents in the index or sector and thus track or replicate its performance. The MER for classical ETFs in Australia is typically between 0.29% and 0.4%. Large investors can deposit those components themselves into the ETF and receive ETF units in exchange.

Hybrid ETFs can be index based or can be actively managed to produce returns which are not in line with defined indices or sectors, in this way paralleling the approach of traditional active funds. Classical ETFs which track indices or sectors typically do so with low MER’s, often between 0.55% and 0.99% per annum. This low cost is one of the key investor benefits provided by ETFs.

ETFs may be appropriate for investors seeking:

• Broad index or sector exposure from one investment

• Close link between the price of the ETF and the value of the assets held in the ETF

• Low cost equity market exposure

• Tradability and hence potential liquidity.

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(c) LPAC Online Pty Ltd - This information is provided as an educational service only for enrolled students of LPAC Online Pty Ltd. No action should be taken on the basis of or in reliance on the information, opinions or conclusions contained in this document. In preparing the information in this document, LPAC Online Pty Ltd did not take into account the investment objectives, financial situation or particular needs of any particular investor. Before making a decision to invest, investors should consider the appropriateness of the product having regard to their relevant personal circumstances. This document is not, and is not intended to be, an offer or invitation for subscription or sale, or a recommendation, with respect to any proposed offering of any other security, nor is it to form the basis of any contract or commitment.

Ticker MER DescriptionAustralian ETFsS&P/ASX 50 SFY 0.29% Largest 50 Australian stocksS&P / ASX 200 STW 0.29% Largest 200 Australian stocksS&P / ASX 300 VAS 0.27% Largest 300 Australian stocksS&P / ASX 200 A-REITs SLF 0.40% Listed property trusts in the ASX 200

International ETFsTotal US Market VTS 0.09% Broad coverage of US marketAll World-ex US VEU 0.25% All country world equity index excluding the USS&P Asia 50 IAA 0.50% Largest 50 stocks across Hong Kong, Korea, Taiwan & SingaporeMSCI BRIC Index Fund IBK 0.72% Index covering Brazil, Russia, India & ChinaMSCI Japan IJP 0.52% Japanese equity marketMSCI Emerging Markets IEM 0.72% Leading companies in 22 emerging countriesS&P Global 100 IOO 0.40% 100 large transnational companiesUS S&P 500 IVV 0.09% Largest 500 US stocksUS S&P Midcap 400 IJH 0.20% US stocks capitalised at US$1bn to US$4bnUS S&P Smallcap 600 IJR 0.20% US stock capitalised at US$300m to US$400mMSCI EAFE IVE 0.34% Index covering European, Australasian and Far East marketsS&P Europe 350 IEU 0.60% 350 stocks in 17 European marketsFTSE / Xinhua China 25 IZZ 0.74% Leading 25 companies in the China marketMSCI Hong Kong IHK 0.52% Hong Kong marketMSCI South Korea IKO 0.63% South Korea marketMSCI Singapore ISG 0.52% Singapore marketMSCI Taiwan ITW 0.63% Taiwan marketRussell 2000 IRU 0.52% US small-cap stocks

Global SectorsTelecommunications IXP 0.48% S&P Global Telecommunications IndexHealth Care IXJ 0.48% S&P Global Health Care IndexConsumer Staples IXI 0.48% S&P Global Consumer Staples Index

CommoditiesGold GOLD 0.40% $A Gold Spot PricePalladium ETPMPD 0.49% $A Palladium Spot PricePlatinum ETPMPT 0.49% $A Platinum Spot PriceSilver ETPMAG 0.49% $A Silver Spot PriceBasket ETPMPM 0.43% $A Basket of gold, palladium platinum and silver prices

Source: ASX, Vanguard, iShares Australia, ETF Securities, PennyWise InvestmentMER: Management expense ratioPowered by www.etfmate.com.au

Local & International ETF Equity ETFs on the Australian Market

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