Exchange-traded funds offer wide investment exposure at lower cost

Diversify, diversify, diversify. No matter how many times that mantra is repeated, it still fails to penetrate the grey matter between some people's ears.

One obvious way to diversify investments is to buy a fund that spreads an investor's small, but hard-earned sum of money over 10, 20, 100 or more investments.

The most common in New Zealand are managed funds, which overseas are commonly called mutual funds or unit trusts.

They operate by trying to pick a basket of investments in companies, bonds, or commodities that the smarty-pants manager thinks will perform better than others in that country or industry.


Investment trusts are similar to actively managed funds, but they trade on stock exchanges.

Here in New Zealand a less well-known fund type is what's called an exchange-traded fund. ETFs are similar to managed funds in that they contain shares, commodities or bonds. The difference is most track an index, such as the NZX or ASX or a bond index. That means the investments in the fund mirror the make-up of that index.

The ETF will buy shares in every company listed in the particular index weighted according to the size (market capitalisation) of each. The idea is that as the basket of shares in the index goes up as a whole, so does your investment.

That index might be the NZX 50 (the largest 50 listed companies in New Zealand), the FTSE 100 in Britain, or the S&P 500 in the United States.

If, for example, an investor chooses to buy shares in the iShares MSCI Singapore fund, he or she gets an investment designed to track performance of those companies listed on the Singapore Stock Exchange.

As companies grow or shrink in size and enter or leave the index that the ETF follows, it is rebalanced to ensure it is tracking the index accurately.

One advantage of ETFs over some other investments is that they are a low-cost way to get exposure to a wide range of investments, says Martin Poulsen, authorised financial adviser at First New Zealand Capital.

ETFs don't take the same level of expertise and manpower to run as a managed fund, so they tend to have lower purchase costs and annual management fees

ETFs are popular in the United States and Australia and are marketed by well-known financial services providers such as Vanguard and iShares.

New Zealand is a small market and there are only five ETF funds available. The five Smartshares funds such as smartTENZ and smartMOZY follow various indices of the New Zealand and Australia stock markets.

In the US the range of ETFs is phenomenal. Most Kiwis will have never heard of some of the obscure indices these ETFs track such as the Dow Jones US Basic Materials Index and the AMEX Semiconductor Index.

There is even a fracking index that tracks the Market Vectors Unconventional Oil & Gas index. The companies on this index are involved in controversial new advances in drilling technology, such as hydraulic fracturing and horizontal drilling.

It's worth noting that just because an index has been created for fracking shares it doesn't mean the companies on that index are mature businesses.

Because the technology is new, so, too, will many of the companies on the index be. "Even though [the ETF] may be following a number of different stocks from a number of different drilling companies in a fracking index, those companies might be penny stocks [shares that trade for less than $1]," says Sam Stanley, head of Smartshares.

It is relatively simple to buy overseas ETFs, says Poulsen, and is much the same as buying shares in Fletcher Building or BHP.

There are charges for buying ETFs through stock exchanges. There is the brokerage charge, smaller agency charges to the foreign broker handling the trade in the country where the ETF is traded, and there may be an annual custodian fee, which, in the case of First NZ Capital, is 0.35 to 0.5 per cent. This is on top of the ETF's management fee.

Some investors choose to open trading accounts directly in Britain or the United States.

Private investor Alan Best has a British-based internet broker because, he says, the brokerage fees are much lower than New Zealand. Trades cost him £11.50 ($22.54) each and he pays a £7.66 quarterly account fee.

Whether someone is trading through New Zealand advisers or directly through an overseas online broker, small trades become expensive because of the minimum fees.

Another option is to buy one of the five Smartshares funds, with the advantage that investors can drip-feed as little as $50 a month into a fund with no brokerage charges.

New Zealand-based ETFs charge higher fees than their overseas cousins, although compared with managed funds they are still low-cost.

Smartshares fees are about 0.6 per cent a year, compared with 1 to 2.5 per cent for a managed fund.

A US-based ETF might charge as little as 0.2 per cent.

Buying an index tracker doesn't negate the need for financial advice, says Robert Oddy, financial adviser at International Financial Planners.

Investors still need to do their homework or get someone else to do it for them. Who's to say that ETFs based on ACT Australian Cleantech Index or the Nasdaq Computer Index are the right fit for an investor's portfolio? And, for instance, "the MSCI global index has been developed by an investment bank for its own purposes to get people to invest", says Oddy. It ignores some of the emerging markets.

Very specialised ETFs have risks. An entire sector may suffer a downturn affecting all or most of the companies in relevant indices. Other risky ETFs are ones that invest in futures; and leveraged ETFs. Leveraging means the fund is borrowing to buy more shares than it could otherwise afford. This magnifies both gains and losses.

Another "risk" is ETFs need to contain every company in the index. If, for example, you believe Fletcher Building or Infratil to be a bad buy, for whatever reason, you will still be exposed to it if you buy smartTENZ.

The top 10 or 50 shares by volume in the market might not perform as well as a hand-picked group of 10 or 50 shares. "They include the good, the bad and the ugly," says Poulsen.

Although the 10 or 50 top-listed companies on the NZX may be big by Kiwi standards, they're minnows internationally and might well be considered by overseas investors to be obscure and risky. While Kiwis might baulk at the thought of investing in the Turkish ISE-30 index, someone living in Istanbul might think similarly about the NZX 50.

Choosing some of the more obscure ETFs such as the fracking or solar energy funds to invest in is sometimes likened to gambling.

While investors can find out all manner of information about ETFs on numerous international websites, they still need to make an educated decision about what to buy.

Then there will be obscure ETFs that could be a good buy. For example, says Oddy, the AIGS agricultural ETF or MOO meat ETF might be good buys thanks to the fact that the middle classes of the developing world are demanding more protein in their diet and drought in the United States and elsewhere has cut production.

Likewise some people who fear for the future of paper money like to invest in gold ETFs that are backed by real gold.

For investors who feel more comfortable buying locally, the good news, says Stanley, is that there are plans afoot to open new ETFs to invest in commodities, bond futures and global shares.

ETF investments do have tax implications. Most of the foreign-run examples - even those in Australia - fall under the Foreign Investment Fund rules, which tax capital gains.

There may also be instances where the investment is taxed in its country of origin and again here.