The failure of Silicon Valley Bank (SIVB) is the latest example of an unexpected event which can rock global markets. Fears of broader financial sector breakdown look to have abated for now, but that doesn’t mean the demise of SIVB won’t have serious implications for markets around the world.
Episodes like the SIVB serve as important cautionary tales, amplified in the current environment in which rapidly rising rates have made the economy fragile. These types of events can be a great reminder to re-examine the assets within your portfolio. Moreover, for investors holding ETFs it is pertinent they know exactly what eggs are in their ETF basket, so to speak.
An ETF tracks the performance of a basket of companies. This basket is the ETF’s index portfolio. One of the major benefits of index tracking ETFs is the diversification and liquidity benefits they can offer. But not all ETFs are created equal and investors should be assessing their investments from time-to-time.
Like a car, a regular service may need to be scheduled and we think, in regards to ETFs there are three key considerations for your portfolios:
- liquidity;
- diversification; and
- purpose
- Liquidity
Activity into ETFs tends to jump at times of turmoil because they’re easy to trade- investors can quickly pare risky positions, shift into safety or place directional bets, according to Bloomberg.
It is important investors understand liquidity as it impacts how quickly investors can access their money and the value of their investments. The two most important points to understand are:
- Definition – a liquid investment can be readily acquired and converted to cash.
- Impact on price – a liquid investment can be bought or sold at a fair value without a significant premium or discount to its fair value.
For example, the ASX provides a secondary market that facilitates share trading. For larger cap shares which trade all the time, such as CBA and BHP, liquidity is high. There are always so many buyers in the market that such shares can be sold at a fair price quickly without impacting the value. Some smaller listed companies are less liquid. There are relatively few buyers so market forces allow them to extract an ‘illiquidity discount’ from anyone who needs to sell. Illiquidity pushes the price down.
ETFs do not have this illiquidity issue as they are listed on the ASX and operate under a set of rules prescribed by ASX known as ‘the AQUA rules’. A key feature of the AQUA rules is the requirement to have a Market Maker to ensure liquidity is maintained.
Market Makers do exactly as their name suggests. They make markets by matching buy and sell orders for investors that want to buy or sell ETFs. This means, as an investor, you are not dependent on there being other investors wanting to sell when you want to buy or other investors wanting to buy when you want to sell. The Market Maker will do it.
The Market Maker holds an inventory of the ETF’s portfolio so that they can always match the supply and demand from buyers and sellers.
A layer of ETF liquidity investors should also consider is the liquidity of the ETF’s constituents. ETFs track an index and to properly underpin an investment fund, an index should be both diversified and liquid.
In terms of liquidity, apart from being able to get in and out when needed, liquid stocks tend to lead to better performance from not having to sell at a discount or buy at a premium when the need arises. Many indices do not have stringent liquidity requirements, so it is worthwhile understanding an index’s liquidity. Think of the BHP example above, with a market capitalisation in excess of $200 billion it is likely its shares can be bought and sold easily. However, it might be more difficult to trade the smallest company (at the time of writing) in the S&P/ASX 200, Novonix, which only has a market capitalisation around $700 million.
In terms of diversification, this leads us to the second key consideration.
- Diversification
During periods of heightened volatility individual stock selection becomes more difficult. By way of contrast, ETF’s enable investors access to a broader investment strategy. But not all indexes are the same. Different indexes have different purposes. Before the phenomenal growth of ETFs, financial market indexes were and continue to be used as a measure of the performance of a particular market or sector. They are used in economic planning, as a simple tool for the media and as benchmarks to judge the performance of individual investments. The most well-known indexes are the country indexes which include the likes of Australia’s S&P/ASX 200 and the S&P 500 in the U.S.
These indexes were not designed specifically to be investable. They do their job well but their job was not designed to service investors in ETFs. The benchmark indexes do not apply any liquidity tests, and they do not approach diversification in a considered way, other than just looking at the company’s market capitalisation.
As a result, these indexes are often not truly diverse. For example, when allocating to a portfolio of 200 or 300 companies an investor would naturally expect more diversification than having 50% of their investment to go to just two sectors, or have 45% invested in just 10 companies. However, that is the reality of what you’re getting when you invest in a fund that tracks Australia’s benchmark indexes. We have recently written about strategies to overcome this here and here.
It is not just these broad market capitalisation weighted indexes that may have unintended concentration risks. Some sector specific or thematic funds may be adversely impacted by one specific stock or subsector. For example, the S&P/ASX 300 A-REITs Index has over 25% exposure to one industrial property, Goodman Group.
Poor index design may also result in constituents being in the portfolio that do not align with your understanding of the fund, or the way it has been marketed. These could lead to variations of performance that are difficult to explain. This leads us to the third key consideration.
- Purpose
One of the most obvious examples of Exchange Traded Funds not doing what they purport to do of late has been in the area of ESG (Environmental, Social and Governance). Funds that claim to be green but whose claims cannot be substantiated have come to be known as “greenwashing.” The greenwashing problem has been highlighted by the International Monetary Fund (IMF), which said proper regulatory oversight needs to be in place to prevent the practice, and to help ensure fund labels reflect how their money is invested. “Labels have become an increasingly important driver of fund flows, especially in the retail [investor] segment of the market,” the IMF said. It said labels must represent funds’ investment objectives.
Australia’s regulator ASIC has responded. As a part of its Corporate Plan, ASIC “will take action to prevent harms arising from greenwashing and to support effective climate and sustainability governance and disclosure”. ASIC has already issued a number of infringement notices for greenwashing and last month launched its first court proceeding alleging greenwashing.
Again, these types of events should remind investors to check their investments.
Fund managers can be tempted to exploit investors growing interest in ensuring their money is doing good for the planet as well as their overall returns. Investors must be vigilant and take time to ask:
- Does this fund truly do what it says it will do?
Review the way companies are selected for the fund. Does it make sense? Are you comfortable with all the holdings? Does it align with the way the fund is marketed? - If the fund says it addresses an issue like climate change, consider how?
Again, consider both the companies included in the fund and why they were included in the context of climate change and carbon emissions. Some people may not be comfortable with the argument that a company like Zoom, for example, takes cars off the road, thereby having a positive effect on the climate.
You could also apply a similar framework to factor funds.
- Do all the companies in the index make sense? For example, a large Australian equity quality index should not include banks by virtue of their high financial leverage ratio relative to the Australian equity universe.
The same logic could be applied to sector and so-called thematic ETFs. Do all the companies in the index make sense? Why for example, would a healthcare focused ETF have an exercise company or an online pharmacy? Their links to the sector or theme is tenuous, at best.
When you look under the bonnet of your ETF, consider liquidity, diversification and the purpose. All investing involves risks, but regular ‘servicing’ is important for your portfolio. As always, we recommend you speak to a financial adviser who is best placed to determine which ETF is right for you.
