Kanish Chugh, ETF Securities

Exchange traded funds (ETFs) are surging in popularity and becoming one of the fastest growing corners of financial services. According to ASX data, ETFs held more than $120 billion in assets at the end of September 2021.

[Editor’s note: To learn about the features, benefits and risks of ETFs, take the free ASX ETF and Exchange Traded Products course.]

The strong growth of ETFs has been driven by financial advisers - the professional money managers who look after other peoples’ wealth. 

While only anecdotal evidence is available, in ETF Securities’ experience, young advisers – under the age of 40 – have been especially welcoming of ETFs. This is because they are less wedded to older types of funds. 

According to Adam Lawrance, the director of Lawrance Private Wealth, advisers like himself are attracted to the low fees and ease of trading that ETFs provide. 

As ETFs follow market indices, which are gauges that measure a group of companies’ share prices, it is easier for advisers to predict how ETFs will perform. “All our clients have a component of their portfolio that is invested in ETFs for the long term,” says Lawrance. 
 

ETFs now built for advisers 

ETF providers – including ETF Securities – have taken notice of financial advisers. Many ETF issuers have started creating ETFs with advisers in mind. 

On this score, one innovation has been thematic ETFs, which have proliferated on the ASX in recent years. Thematic ETFs invest in “megatrends” which are one-off shifts in society or the economy that change the way we live forever. Mass production of cars in the 1930s, which created not just a new form of transport, but also created modern freeways and the suburbs, is an example of a megatrend. 

Thematic ETFs on the ASX right now include robotics ETFs, and renewable energy themed ETFs such as solar power, battery technology and hydrogen. In each instance, advisers have been among the major supporters. 

Lawrance says that thematic ETFs allow advisers to add “flavour” to portfolios and put their clients into investments that suit their needs or views. “You can safely choose your own flavour to suit the client’s preferences, ethics or values,” he says. 
 

Potential weaknesses and risk

However, ETFs are not perfect. They also have potential weaknesses which advisers should keep in mind. One potential weakness is the use of market capitalisation weighting – which is where ETFs invest in companies’ shares or bonds, based on size. 

In Lawrance’s view, market cap weighting is especially risky for bond ETFs as they buy the most heavily indebted company’s bonds the most. “Naturally risks are involved whereby the ETF will end up holding the company with the largest pile of debt,” he says. 

ETF adoption is likely to continue, with the help of advisers who have become their biggest users. And as more advisers start using ETFs, more and more ETFs will be made with them in mind. Thematic ETFs may be only just the beginning. 

Robin Bowerman, Vanguard

While it seems like ETFs have in the last few years become the investment product of choice for personal investors (young and old, new and seasoned alike), it would be remiss not to recognise the essential role financial advisers had – and still have – in driving their success in Australia.

Before ETFs became a trending topic on social media and before the rise of the ‘finfluencer’, financial advisers were amongst the first to appreciate the many benefits of ETFs and how they could be incorporated into a client portfolio not only to generate returns, but to diversify and stabilise. 

According to the latest Vanguard/Adviser Ratings advice landscape report, ETFs are now the fourth most preferred investment solution for advisers, just behind direct shares and ahead of SMSFs, managed accounts and LICs. 

So, why are ETFs so popular with advisers, and how are they being used to build and maintain client portfolios?
 

Low cost, broad exposure 

The 2020 Investment Trends ETF report found that advisers’ use of ETFs in client portfolios has quadrupled since 2008, with 80 per cent of advisers citing ‘diversification’ as their top reason for using ETFs, with ‘competitive pricing’ and ‘brings down overall portfolio fees’ as their second and third. 

Interestingly, portfolio diversification became the top priority for advisers and their clients for the first time since 2018, trumping the usual focus on costs. 

Spurred on by the pandemic and the resulting year of extreme volatility, advisers likely emphasised more than ever the need for clients to be broadly diversified across different industries, asset classes and regions to mitigate market risks. 

To this end, index ETFs can be a one-stop investment shop for diversification needs. 

Many ETFs combine hundreds of securities in just one fund, providing exposure to entire markets and making them inherently diversified and relatively lower in risk compared to individual shares and bonds. 
 

Targeted portfolio construction 

On top of this, recent growth in the ETF space has allowed for more innovation and efficiencies of scale, translating pleasingly into a wider product offering, lower fees, and greater choice for advisers when constructing client portfolios. 

Active ETFs and Environmental, Social, Governance (ESG) ETFs, for example, are gaining popularity with advisers for their ability to help achieve more specific portfolio goals. 

For clients seeking to achieve greater returns than the broad market or wanting to access a curation of securities by select fund managers, active ETFs allow for such investment preferences without the same high fees associated with actively managed funds. 

ESG ETFs also offer clients the ability to invest according to their values without having to compromise on costs, accessibility or performance. 
 

Effective and efficient 

From an adviser’s perspective, ETFs also save time. Instead of constructing a similar client portfolio using individual securities, advisers can mix and match “ready-made” ETFs to achieve their target exposure – be that active and index, domestic and international, or even particular themes. 

A mix and match investment strategy many advisers have adopted is the core-satellite approach, where ETFs are used as the stable, core building blocks of a client portfolio, and individual securities or actively managed funds are used as satellites to complement. 

Ultimately, ETFs are presenting a very efficient way to construct portfolios – allowing advisers greater capacity to spend on other important priorities, such as strengthening client relationships, developing new connections, and upskilling, rather than selecting individual securities and building diversification from scratch.  

Vinnie Wadhera, BetaShares 

The number of financial advisers using ETFs has more than doubled over the last decade [i] - no surprise, given surging demand from Australian investors for ETFs.

As the industry has expanded, financial advisers have become increasingly sophisticated in the ways they are using ETFs to satisfy the objectives of almost every type of investor, from early-stage accumulators through to retirees.

Diversification benefits and low costs are among the main reasons advisers use ETFs [ii] as building blocks for core asset class exposures in portfolio construction. This includes core allocations to Australian equities, international equities, and fixed income.

International equity exposures continue to be the number one ETF asset class category used by advisers [iii].  This asset class has received over $9 billion of inflows year-to-date to 30 September 2021 [iv]. 

For this asset class advisers use ETFs for both broad market exposures and satellite thematic exposures. 

Advisers cite access to specific markets as an important factor in fulfilling demand from clients for exposure to thematics or megatrends as part of the satellite component of their portfolio allocation.

In the 2020 BetaShares Investment Trends survey, more than half the planners surveyed mentioned ‘access to specific types of investments/asset classes’ and ‘access to specific overseas markets’ as reasons for using ETFs [v].

Advisers are using ETFs to help their clients invest in global thematics like cybersecurity, robotics and artificial intelligence, and climate change innovation.

Thematic ETFs have seen $1.46 billion in flows so far this year to reach a total of $3.56 billion in funds under management (FUM) [vi], up 54% since the end of 2020 [vii]. 
 

Rise of smart beta

The majority of ETFs are still those that aim to track an index based on market capitalisation, such as the ASX 200 or the S&P 500. However, there has been increasing adoption of ‘smart beta’ ETFs, particularly in the fixed income asset class. These ETFs take an index-tracking or rules-based approach based on improvements on issuer weighted methodologies.

Advisers are welcoming the innovations that have been implemented into the design of new fixed income index methodologies, with such ETFs being used to replace or complement existing active managers. 
 

All in on ESG ETFs

The proportion of financial planners who provide advice on responsible investing has doubled in the last five years, from 19% in 2015 to 40% in 2020 [viii],  and we’re observing strong adoption of ETFs for ESG portfolios.

[Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to licensed financial adviser before acting on themes in this article].

The ethical ETF industry has seen $1.8 billion in flows this year to reach a total of $5.4 billion in FUM [ix],  up 95% since the end of 2020 [x].  BetaShares’ two Sustainability Leaders ETFs, (ETHI and FAIR), now hold more than $3 billion in FUM between them [xi]. 

This demand is being driven by clients of all types and ages. Around a quarter of retirees and pre-retirees requested their planners recommend responsible investing products, while one in five investors below the age of 50 did so [xii]. 

Transparency is particularly important in this category, and ETFs provide high transparency in terms of index methodologies, screening criteria, and the end portfolio holdings which are publicly available.
 

Summary

The evolution of the ETF industry means that today it’s possible for advisers to construct and maintain complete, diversified investment portfolios for clients with a core set of ETFs.

In addition to cost-effective building blocks for broad-based exposures, the range of ETFs now available has made many thematic exposures accessible, allowing advisers to tap into high-growth areas of opportunity using ETFs that traditionally had only been accessible via active managers.