When the financial wizards of the world thought up exchange-traded funds (ETFs) many moons ago, not many could have predicted the impact the products would have on the industry today.

Interest in ETFs has exploded in recent years. In April 2016, the Australian ETF market sector boasted $23.16 billion in funds under management – a record high – while an unprecedented number of investors now say they intend to make an ETF investment in the next 12 months.

The sector is on an upward trajectory, according to the BetaShares/Investment Trends ETF Report, and shows no signs of slowing down.

“This research shows that ETFs are well on their way to becoming mainstream in Australia, just like they are in major global markets,” says BetaShares’ managing director, Alex Vynokur.

“Last year was a watershed for the industry in Australia. The report suggests that this fast growth should continue.”

Yet while ETFs continue to rise in popularity, so does the number of products on the market, thanks to more issuers wanting a piece of the action. Investors – and therefore advisers – now have a wider range of ETFs from which to choose, and there are more on the way.

“What’s really happened in the last year or two is what I refer to as ETFs 2.0. You’re now starting to see different flavours and variations of indices,” says Morningstar director of manager research, Tim Murphy.

“You’ve now got ETFs across every major asset class. You’ve got individual countries and currencies in which you can allocate to. It’s just an ever-increasing range of options to choose from.”

More choice also means financial advisers have more to work with when constructing portfolios for their clients. However, that does not necessarily make the job easier – in fact, it can make it harder.

Some industry experts argue that products are becoming more complex, putting pressure on advisers to do their homework before selecting an ETF for their client.

“The newer ETFs tend to be more complex than the earlier days; the work involved with them becomes a bit more complex,” Mr Murphy says.

“As the burden of work becomes more detailed and more important, as the nature of the sector continues to evolve, using detailed research becomes more important in weeding out less desirable ones and focusing on what are worthwhile investments.”

Growing demand

Issuers now regularly spit out new exchange-traded products and this can be attributed to the strong demand from investors.

According to the BetaShares/Investment Trends ETF Report, the number of investors using ETFs in the 12 months to October 2015 increased by 37 per cent to 202,000, up from 146,000 the year before and exceeding growth projections.

Also, 71 per cent of investors surveyed for the research said they would re-invest in ETFs in the next 12 months.

Morningstar’s Mr Murphy says low cost and diversification continue to be among the top reasons for ETFs gaining popularity.

“If you are an Australia-based investor and you wanted to invest in US small cap stocks, before an ETF came along, that would have been something you could do but [it would] be quite difficult to facilitate,” he says.

“Similarly, with investing in other commodities or currencies or single sectors overseas, ETFs made it a lot easier to invest in a broader range of underlying investments.”

Shaun Parkin, head of SPDR ETFs, Australia at State Street Global Advisors (SSGA), says it is possible to achieve a good amount of exposure with just a few different investments.

“You can have Australian equities, global equities, fixed income, just using ETFs and potentially, using only five or six underlying components,” he says.

“Before, if you were looking at single stocks, you had to have 20 or 30 underlying components to get diversity.”

In addition to offering diversity, ETFs are known for being easy to buy and sell, says Jon Howie, head of iShares Australia.

“You can buy them on the stock exchange just like any other share, and we know that Aussie investors are very comfortable buying listed securities,” he says.

And while, according to the BetaShares/Investment Trends ETF Report, diversification remains the primary reason that individual and SMSF investors use ETFs, access to overseas markets has become the second-most important reason for seeking them out, overtaking low cost.

Turning to the adviser perspective, 90 per cent of financial planners cited low cost as the top reason for their recommending the product.

Morningstar’s Mr Murphy says greater competition in the ETF space has led issuers to reduce their fees – a trend he expects to continue. iShares and SPDR, for example, recently slashed fees to as low as 0.15 per cent per year for their flagship Australian equity ETFs.

“You’ve seen price competition in some of the bigger indexes. I think over time you will likely see fees come down as [competition] gets bigger,” he says.

Finally, more investors are choosing passive ETFs for their tax efficiency, says VanEck Australia’s managing director, Arian Neiron.

Because actively managed funds change weightings or companies regularly, they create higher capital gains tax liability each year.

“Most investors using ETFs are aware of the key benefits, such as diversification, transparency and low cost, but one of the most unknown advantages of ETFs is their tax efficiency,” he says.

“Many investors do not look at the after-tax return; instead, they typically only look at the gross performance return. It is important to consider after-tax returns when comparing investment products.”

Morningstar senior research analyst Alex Prineas says that a typical actively managed fund might have a portfolio turnover ranging from 20 per cent to more than 100 per cent per year.

“So that means you’re realising capital gains all the time and may not be benefitting from the capital gains tax discount for holding stocks for more than a year,” he says.

“In contrast, turnover for such ETFs as STW has never exceeded 10 per cent over the past decade.”

The rise of alternatives

While a majority of ETFs continue to track traditional, market capitalisation-weighted indexes, in recent years there has been a shift toward alternatively weighted – or smart beta – products.

VanEck’s Mr Neiron says these products represent the best of both active and passive investing.

“New innovations in index development are revolutionising the ETF market both globally and here in Australia,” he says.

“Smart beta strategies offer the best of both active and index-tracking portfolio management while operating within a passive management framework which is rules-based, transparent and cost-effective,” he says.

Once considered ‘exotic’ and risky, smart beta products today are thought to be part of ‘Chapter 2’ of the ETF evolution story, says head of ANZ ETFS Kris Walesby.

“What people do when they chase a market capitalisation index is they are actually saying to themselves is ‘biggest is best’,” he says.

“To me, smart beta is just a different way of looking at it. What it is saying is, ‘we think that you would get a better outcome, if you were looking for yield, if you apply certain rules to make sure you got a much higher likelihood of being in a higher-yielding stock’.”

iShares’ Mr Howie would agree. Smart beta issuers, he says, are simply offering investors new ways to enjoy the benefits of ETF products.

“Other than just using market-cap, the portfolio construction methodologies are around trying to access particular sources of return – for example, low volatility stocks or maybe value companies,” he says.

“I think it’s just a natural extension of offering the benefits that ETFs provide. It’s just another way to invest.”

Some experts, however, would argue that smart beta products are riskier. Vanguard’s head of ETF capital markets, Damien Sherman, says advisers should understand that most smart beta products involve “taking a bet”.

“They’re active products that are taking a bet on a particular theme within that asset class,” he says.

“Advisers need to look at the product specifically and understand exactly how that product is getting its exposure and what is contained within that product. Has it got any leveraged in it? Has it got any synthetic instruments in it?

“We do see a lot of new products coming out on the market so with all of this extra choice, advisers need to be more aware of what they’re investing in. They need to do more homework,” he says.

SSGA’s Mr Parkin, however, argues that ETFs continue to be simple products, despite the rise of alternatives.

“An ETF still has to match a benchmark. It still has to be passively managed. It is still restricted by how many derivatives are in it. In that space – in the ETF space – it’s still very simple,” he says.

“As far as smart beta [is concerned], if you’re looking at that as increasing the complexity, I don’t think [it does] so as long as it’s very defined in the benchmark methodology. As long as the rules are very clear, as long as the methodology is very clear, I think it is still very simple for investors to understand what they’re investing in.”

Picking the right index

So, how can advisers learn which ETF is right for their clients? According to Morningstar’s Mr Murphy, there are a few important factors they must keep in mind.

For example, he suggests advisers look at how long an index has been around and make sure it was not created too recently.

“In recent years, you’ve seen index providers just making indexes up because they know someone wants to launch an ETF off the back of it to raise money,” he says.

“[Advisers should ask] what’s the idea or purpose behind the index creation? Does it have any long-term merit? Or is it just an index created on a Tuesday based on a data mine factor that worked well for the last couple of years?”

Mr Murphy also recommends looking at how the index “comes together”.

“Is it a long-term, steadily moving index or does it chop and change every other quarter with rebalancing?”

Vanguard’s Mr Sherman says advisers must first work out how they want the portfolio to be constructed, and then look at how broad the index is within the particular asset class.

“The key things that we think advisers should be looking for is how broad the index is [and] is it by a reputable provider?” he says.

SSGA’s Mr Parkin says it is also important for advisers to understand the methodology within an index.

“You have to dig into the benchmark and make sure that you understand what the ETF is tracking,” he says. “So, go to the facts sheet, go to the website of the issuer, find out what the country mix might be and understand what you’re actually getting exposure to.”

Costs also play an important role when choosing a product, says ANZ ETFS’ Mr Walesby, noting that this may be what breaks the tie between two matching indexes.

“If you have two indexes which are identical, the key there then is to look at the ‘total cost of ownership’, which is all parts of the cost structure to the investor,” he says.

iShares’ Mr Howie adds that advisers should consider the performance of the ETF relative to its benchmark when calculating costs.

“Because basically what you’re doing when you buy an ETF is you’re buying exposure to a benchmark, or to an underlying asset class,” he says. “If you’re not actually receiving the performance of that benchmark, that’s a real cost to you as an investor.

“If you just consider the management expense ratio you would buy the ETF that costs 18 basis points.

“But when you consider that, in some cases, the ETF that costs 18 basis points may underperform the benchmark by 10 basis points, it’s actually 8 basis points more expensive than the ETF that costs 20 basis points and matches its benchmark perfectly.”

Gaining ‘true’ diversification

In addition to looking at indexes and costs, advisers must also be certain that the products they choose offer enough diversification, Morningstar’s Mr Murphy says.

“We’re a fan of encouraging people to embrace diversification because that’s one of the few free lunches out there in investing,” he says.

“I think you have to be careful when looking at the newer range of ETFs – they are starting to get narrower and narrower, and therefore have less diversification in them.

“Always come back to: ‘What is the exposure I am aiming to achieve for my client?’”

One way to be certain is to check the number of stocks in the benchmark or fund as well as any overweighting toward particular sectors, says SSGA’s Mr Parkin.

“You might find some ETFs are heavily weighted toward the US if they’re market cap-weighted,” he says.

“If you’re looking for diversification, make sure that the ETF is actually providing that.”

iShares’ Mr Howie says advisers should make sure they are not “doubling up” in certain areas.

“Sometimes we see clients own bank stocks because they like the dividends. They say ‘I’m going to buy an ETF because I want a more diversified portfolio’ but they go and buy a dividend ETF,” he says.

“If you’re buying a dividend ETF that is just doubling up on bank exposures, is that really what you want?”

Mr Howie concludes that it all comes back to the need for advisers to do their ETF homework.

“Just make sure you understand what is going on under the hood and when you’re considering diversification, buy ETFs that are truly diversifying your portfolio,” he says.