Saturday, 19 April 2008

ETFs on the ASX: Good or Bad?

ETFs are exchange traded funds. You can buy and sell them on the Australian Stock Exchange and they act like a mutual fund unit. In America the ETF market is highly developed, offering customers countless products. In Australia, however, the only ETFs I can think of are the country-specific ones offered by iShares, the Australian index ETFs by State Street Global Advisers, and GOLD.

I don't have any ETFs at the moment. The problem is that I only work part-time and if I dollar cost average (e.g. invest $500 per fortnight) then I will pay brokerage costs (costs of buying or selling shares). On online brokerage Commsec, you have to pay $20 for transactions less than $10,000. Most traditional mutual funds (not all) do not charge you anything to put money in. So why bother with ETFs at all? ETFs usually have very low management fees, lower than their mutual fund equivalents. For example, Vanguard Australian Shares Index Fund has an MER of 0.70 per cent while the SPDR ETF that tracks the ASX200 (ASX:STW) has an MER of 0.286 per cent. So basically using mathematics I am able to calculate that for the ETF to be worth it I would have to invest about $5,000 in one go for it to beat the Vanguard index fund given brokerage costs of $20 per transaction. In order for you to get the most bang for your buck you should invest $10,000 each time. A 0.70 per cent fee on that amount means you pay $70.00 per year. A 0.286 per cent fee plus $20 brokerage on $10,000 means you pay $48.60, which means you save $21.40 per $10,000 you invest if you use the ETF.

Obviously at this moment I don't have $10,000 or even $5,000 lying around, and so ETFs are not not practical for me. In order to save up that amount, I would have to wait for a long time. ETFs will be something I'll think about when (or if) I start earning more.

I have no interest in GOLD, so I won't talk about that. I will talk about the iShares ETFs. As a simple rule I aim to invest half in Australia and half outside Australia. Australia only makes up 2 per cent of the world economy, but I invest 50 per cent here because of currency worries. If I invested almost all my money overseas then fluctuations in the Australian dollar will have too much impact on investment returns. Vanguard and Hesta seem to believe the same thing. This is why I have been looking at the iShares ETFs because they provide a window into investing outside Australia. I am particularly interested in IVV, which tracks the U.S. S&P500 Index. It has an MER of 0.09 per cent! I think this must be because the American financial system is highly developed and thus they are able to get economies of scale going. Two ETFs provided by iShares that I think are a waste are IOO and IEU. IEU is the biggest waste. You pay an MER of 0.60 per cent to invest in European companies. IVE claims to track the MSCI EAFE Index (Europe, Australasia, and Far East). However, if you look carefully at the country makeup of IVE you'll notice that about 90 per cent of it is in European countries. So essentially IVE is a European ETF, yet its MER is 0.34 per cent. IOO invests in the top 100 companies in the world. The problem is that it is hardly global. About half of them are European and half are American, and the MER is 0.40 per cent. Why not buy half IVV (S&P500) and half IVE (EAFE) and pay a weight MER of 0.215 per cent?

The most expensive ETF provided by iShares is IEM, which invests in emerging markets. Emerging markets make up 40 per cent of the world economy now, so having some exposure I think is a good idea. The monopoly of Europe, America, and Japan may be a thing of the past. iShares has separate ETFs for emerging countries (IZZ invest in China with MER 0.74%, IKO in South Korea with MER 0.68%, and ITW in Taiwan with MER 0.68%). However, I think it's better to invest in IEM and get not only China (14.8% of IEM), South Korea (12.8% of IEM), and Taiwan (9.1% of IEM) but also other emerging countries like Russia, Brazil, and Mexico.

The developed Asian countries all seem to have similar MERs: IHK for Hong Kong with MER 0.52%, IJP for Japan with MER 0.52%, and ISG for Singapore with MER 0.51%.

Update 19/4/2008
My calculations may have been slightly wrong when I said that you need to invest $5000 at once for the Australian share ETF to beat Vanguard's Australian share mutual fund in terms of cost. The difference is that for the ETF the $20 brokerage is paid once and that's it. For Vanguard, the extra management fee is taken out every year for the rest of your life, not just for the first year. To calculate this then is much more complicated. I think I'll need to know how to find the present value of a perpetuity. Unfortunately I've forgotten how to do that. Nevertheless, intuitively this means that investing in ETFs is even more cost-effective than I thought. You probably only need to invest $1,000 or less at a time for its costs to be equal to the cost of the traditional mutual fund.

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