This month: Marcus Padley

Investing in ETFs reduces volatility and risk but there are pitfalls

The popularity of exchange traded funds (ETFs) is overstated in Australia. It is a tiny market here with $23 billion invested, which is just 0.12% of the All Ordinaries market cap. It's certainly growing but it is way behind managed funds, which hold $2.8 trillion, and is a tiny fraction of the ETFs globally, which is a market worth over $3 trillion. It is, however, of a similar size to the listed investment company (LIC) market in Australia, which is worth $32 billion.

ETFs appear to be a thriving giant of an industry here because of prolific marketing. But that's because the firms that are marketing them are huge US companies for which the Australian presence is subsidised by their international ETF business.

The main attraction of ETFs for me would be for people who have given up on the volatility of shares. Instead you might choose to simply trade ETFs. It's a lot easier making a few decisions each year about which country and currency to be in than it is managing 20 separate equities.

In the ETF world your investment concerns boil down to timing asset allocation rather than managing events in individual shares, which is more risky and volatile, as anyone who traded through the last results season will testify. Results and AGM seasons are becoming a bit like being on the battlefield during an artillery barrage. You never quite know when you're going to get blown up.

Talk to some traditional stockbrokers and they will also tell you that, for them, trading shares is now a poor man's game. Transaction broking is not a reliable business and they are all trying to move into “wealth management”, a fee-oriented business that hopefully generates a more reliable income than starting each day with a blank book looking for excuses to make clients' trades.

A lot of financial advice now tells clients that the way to manage money is managing asset allocation across classes, not by picking individual shares. Dealing in asset classes instead of stocks is a great way to get out of being responsible for stock advice but for some it is the obvious way to go. One drawback is that asset allocating instead of stock picking will bore you with its lack of action and volatility if that's what you're used to.

It will, however, suit anyone who is feeling that “there must be a better way” to avoid the volatility, profit warnings and stress of managing an individual share portfolio. Trading ETFs, managed funds or LICs alone is putting yourself in the slow lane and this is the ETF industry's best pitch, in my opinion. “Stock picking is too hard, buy ETFs.” It's a bit like Dudley Moore's terribly successful advertising line in Crazy People in 1990. “Buy Volvos – they're boxy but they're good.” ETFs are boring but they're safer.

With ETFs and LICs you can also attempt to do what a lot of financial advisers do: assess your risk profile then direct your money into asset classes in different percentages depending on how much of a chicken you are. Growth, conservative, balanced or cash – just pick your percentages and it's done. But don't think that's all there is to it. To truly get ETFs and LICs or managed funds right, a bit of brain is still required.

For an asset-allocation-style investor the returns come not from holding diversified or specific ETFs but from timing your exposure to the markets. ETFs are a bull market instrument that is deserted in a bear market. Sure, you can buy and hold but if you want to protect yourself from market risk, from a crash, from a GFC, you still have to pay attention and time the markets just as you would time a stock. Of course, timing an ETF over an index is like timing stocks but in slow motion. You have much less volatility and far more time because most of them don't move much and you are not having to make a lot of stock-specific decisions.

The bottom line is that buying the big, diversified, passively managed ETFs over markets and other major asset classes are for those who want a quieter life.

Of course, there are some pitfalls. The industry has overstepped the mark with some of its active ETFs. It should have stuck to its knitting. But no, it couldn't resist. Now we have all sorts of momentary fads available through dicky ETFs. As one colleague so rightly says, it's a bit like brokers listing at the top of the market in 2007. When an ETF exposing you to a particular theme is issued, it's a sure sign the fad is over.