ETFs: How do I use them and what do they cost?

The number of Australians investing in ETFs is expected to top 2 million in 2023, up from 420,000 four years earlier, according to the 2022 Beta Shares/Investment Trends annual Exchange Traded Funds Report.

Some of the most enthusiastic early adopters of the products were SMSF investors and their numbers continue to grow – reaching 400,000 in 2022, up from 135,000 just three years earlier. More than 20% of investors who hold ETFs do so via an SMSF.

As you can see in the table at the end of this article, SMSF investors mostly use ETFs to gain exposure to global shares or as a passive investment in the broad Australian share market. But as the market expands, other self-directed investors and their financial advisers are catching on.

Even though the number of SMSF investors in ETFs continues to grow strongly, the average age of new adopters is under 40.

The key benefits of ETFs are generally cited as convenience, liquidity, transparency and cost effectiveness (see table of fees later in this article). They provide instant diversification with one ASX transaction, with easy-to-locate online disclosure of underlying investments, fees and performance. The main reasons SMSF investors give for investing in ETFs, according to the BetaShares/Investment Trends report, are:

• Diversification (72%)
• Access to specific overseas markets (52%)
• Time saving compared to investing in individual stocks (50%).

What investments do they offer?

While passive index ETFs which mirror a benchmark such as the S&P/ASX 200 Index are still the most popular core holdings, there is a growing number of actively managed ETFs that target niche markets or strategies.

You can buy ETFs to invest in all the major asset classes – shares, property, cash and fixed interest, local and global – as well as geographic and industry sectors such as emerging markets, healthcare and technology stocks.

As the market develops, thematic ETFs are becoming available covering global companies in emerging sectors such as artificial intelligence (AI), robotics, cybersecurity, gaming, energy transition metals and cryptocurrency. High income ETFs are popular, as are ethical or sustainable investments, especially among younger investors.

You can also use ETFs to invest in infrastructure, commodities and currency, assets that were previously difficult for individuals to access.

With new products listed regularly, where is a new investor to start?

The answer is to know where you are going.

Have a game plan

It is much easier selecting investments if you know what you are aiming for. To use a football analogy, you won’t win the game by kicking the ball around without looking up to check where the goal posts are. The investment game is no different. You need to be clear about your goals and stick to your game plan.

If you are reading this, then it’s a safe bet that one of your goals is a financially secure retirement. To achieve that goal, along with medium-term goals such as a home deposit, you will need a diversified portfolio of investments designed to ride out market ups and downs along the way.

To create a portfolio that provides your desired level of capital growth and income when you need it, there are three factors you need to consider:

• Your age and stage of life
• Your investment timeframe
• Your appetite for risk (and aversion to short-term losses).

The answers to these questions will determine the percentage of your portfolio you allocate to higher risk growth assets (shares and property) and lower risk defensive assets (cash and fixed income).

Generally, the younger you are, the more weighting you can give to growth assets in your portfolio because you have time to ride out short-term market fluctuations. While this holds true for retirement savings held in your super fund, you may need to increase your allocation to more conservative cash investments outside super to cover shorter-term goals such as a car or holiday.

Investors nearing retirement are generally advised to reduce risk by dialling down their allocation to growth investments. This is to ensure you have access to a steady income stream in retirement without having to sell down investments and crystallise losses during a market downturn. But with today’s retirees facing the prospect of more than 20 years in retirement, some exposure to growth assets in retirement phase is important.

In practice, your personal risk tolerance will determine the most appropriate mix of growth and defensive assets as you move through life.

ETF strategies to build your portfolio

ETFs can be a cost-effective way to build a diversified portfolio from the ground up, or to plug gaps and provide diversification to an existing portfolio.

Core-satellite strategy

A core-satellite strategy combines ‘core’ passive investments to gain exposure to a broad market such as Australian or global shares, property and fixed interest with ‘satellite’ investments in market sectors, regions or difficult-to-access asset classes.

Core component

Core holdings are designed to be bought and held long term. The aim is to provide returns that track one or more market indexes in one low-cost transaction.

Active fund managers who aim to beat an index have a mixed track record, with many underperforming their benchmark index for lengthy periods. They also charge higher fees than passive index funds due to their high management costs and portfolio turnover. The upshot is that index funds often provide superior performance at a lower cost.

The traditional function of a core portfolio is to gain exposure to a range of asset classes so that poor performance in one asset class won’t have a catastrophic impact on your overall returns. You could construct your core portfolio in one hit with a diversified ETF that invests across the major asset classes. The more common approach is to invest in several ETFs, each with exposure to a single asset class.

Here are examples of the two approaches (for illustrative purposes only, these are not recommendations):

• Alongside its single asset funds, Vanguard offers pre-mixed diversified ETFs with investments in shares for growth and fixed interest for income. Depending on your risk profile, you can choose between a Conservative, Balanced, Growth or High Growth Diversified Index Fund.
• iShares has core ETFs covering Australian shares, international shares, Australian fixed income, international fixed income and Australian cash. It also has a portfolio builder tool on its website that allows you to name an investment sum and allocate a percentage to each of the core ETFs. You will be given an aggregate fee for your final portfolio and a breakdown of underlying investments. If you invest through a financial adviser, you may be offered a core portfolio of these ETFs on an investment platform but additional platform and advice costs will apply.

Alternatively, you can select core ETFs from various ETF providers and build your own core portfolio.

Satellite component

Once you have your long-term core strategy in place, satellite ETFs can be used get exposure to sectors or regions that offer shorter-term opportunities.

For example, you may think the chances of a global recession are increasing and decide to tilt your portfolio towards Australian shares and property. As you can see in the table below, that was a popular strategy with SMSF investors.

A satellite strategy can also be used to complement or plug gaps in your core holdings. For example, there are few opportunities to invest in global technology stocks in Australia. If you want to get exposure to the world’s leading technology companies but don’t want to pick stocks, you could invest in a global technology ETF or a Nasdaq 100 Index ETF that includes big tech stocks such as Meta, Apple, Google and AI/software darling Nvidia. These ETFs also feature in the SMSF top 20 list below.

ETFs can also add otherwise difficult-to-access asset classes to your portfolio. Think international shares and bonds but also commodities, gold and currencies.

What do they cost?

ETFs are generally regarded as a cost-effective way to build a diversified portfolio or to add to an existing portfolio for three reasons:

• The management fees they charge are generally lower than the fees for comparable unlisted managed funds.
• Most ETFs are passive index funds, so management costs are low as are portfolio turnover costs because their underlying assets are not actively traded. Active and thematic funds tend to have slightly higher fees.
• Although you pay brokerage to buy and sell an ETF, they are less costly than buying a diversified portfolio of direct shares or listed securities with separate brokerage fees for each transaction.

The table below shows the management fees charged for the 20 most popular ETFs used by SMSFs as at 30 June 2022. The list is compiled by SMSF software provider BGL, with the latest management fees available from ETF websites. Funds are ranked by the percentage of SMSFs on the BGL platform holding these ETFs. Management fees range from as low as 0.03%  for the popular Vanguard US shares funds, to 0.69% for the GlobalX Battery Tech & Lithium ETF. Growing competition in the market has put downward pressure on fees; just three years ago the highest fee in the top 20 was 1.35%.

Table: Management fees of the top 20 ETFs held by SMSFs (30 June 2022)

Rank	Security code	Name	% of  funds with ETFs that hold this security	Management fee % per yr
1	VAS	Vanguard Australian Shares Index ETF	15.24	0.10
2	VAP	Vanguard Australian Property Securities Index ETF	9.79	0.23
3	VGS	Vanguard MSCI Index International Shares ETF	8.80	0.18
4	STW	SPDR S&P/ASX 200 Fund	8.67	0.13
5	IVV	iShares S&P 500	8.06	0.04
6	QUAL	Vaneck MSCI International Quality ETF	7.73	0.40
7	NDQ	Betashares Nasdaq 100 ETF	7.40	0.48
8	VHY	Vanguard Australian Shares High Yield ETF	6.77	0.25
9	IOO	iShares Global 100 ETF	6.28	0.40
10	XARO	ActiveXArdea Real Outcome Bond Fund	5.81	0.50
11	IXJ	iShares Global Healthcare ETF	5.35	0.40
12	MVW	Vaneck Australian Equal Weight ETF	5.25	0.35
13	VEU	Vanguard All-World ex-US Shares Index ETF	5.09	0.08
14	VTS	Vanguard US Total Market Shares Index ETF	4.81	0.03
15	VGAD	Vanguard MSCI Index International Shares (hedged) ETF	4.75	0.21
16	ACDC	GlobalX Battery Tech & Lithium ETF	4.42	0.10
17	VAF	Vanguard Australian Fixed Interest Index ETF	4.16	0.10
18	HACK	Betashares Global Cybersecurity ETF	4.07	0.67
19	MVA	Vaneck Australian Property ETF	3.39	0.35
20	QHAL	Vaneck MSCI International Quality (hedged) ETF	3.35	0.43

Source: BGL, various

How do I compare ETFs?

If you are considering building a core portfolio with ETFs, or adding ETFs to improve diversification, check out the websites of the major Australian issuers first.

Don’t just look at management fees but compare the underlying investments, index benchmarks and performance of like funds from different issuers.

The top ETF providers operating in Australia are:

• Vanguard
• iShares (owned by BlackRock Investment Management)
• BetaShares
• Magellan
• VanEck Australia
• SPDR (owned by State Street Global Advisors)

The first three account for 63% of all money invested. Other issuers include Russell Investment Management, GlobalX (which took over ETF Securities in 2022), Hyperion and many small providers.