ETFs vs. Managed Funds: Which investment vehicle is right for you?

Exchange Traded Funds (ETFs) have gained significant popularity in the past 8 years, with total investments in Australian ETFs soaring from $20 billion in mid-2015 to over $150 billion by mid-2023, representing a remarkable growth rate of more than 27%. This surge can be attributed to the compelling advantages ETFs offer over traditional managed funds.

What is an ETF

An ETF is a managed investment vehicle that is publicly listed on the Australian Stock Exchange. These funds typically hold a basket of shares that make up an index, such as the top 200 Australian stocks in the case of an ASX200 ETF like A200 or IOZ. This structure provides investors with a straightforward, cost-effective way to diversify their portfolios across various sectors, asset classes, or geographical markets.

To invest in an ETF, you’ll need an account with a share broker. Many investors opt for online share brokers like CommSec or CMC Markets due to their cost-effectiveness for purchasing shares in listed ETFs

Costs associated with ETFs

Investing in an ETF involves two main costs:

  1. Brokerage fees: These fees are incurred when you buy the ETF. For instance, CMC Markets charges $11 for transactions under $11,000 or 0.11% for transactions exceeding $11,000, making it quite cost-effective.
  2. Management fees: The index ETF provider charges an annual management fee, typically ranging from as low as 0.03% to no more than 1% per annum. Actively managed ETFs may have higher fees, reaching 2% to 3% per annum. Developed market and diversified ETFs usually cost within the 0.20% to 0.40% per annum range, while emerging market ETFs tend to be pricier, ranging from 0.67% to 1.0% per annum.

For example, investing $10,000 in the US S&P 500 index (IVV) would incur only $11 in brokerage fees and $3 per annum in management fees, making it an economical way to access investment markets.

How do they operate

An ETF requires several parties:

  • Issuer and fund administrator: Entities like BetaShares, iShares, and Vanguard administer the ETF, including tracking the underlying index and managing expenses. They charge investors a percentage fee.
  • Market Maker: Every ETF must have a market maker responsible for ensuring liquidity in the market. Market makers facilitate buying from sellers and selling to buyers to maintain efficient trading. This ensures you can buy and sell ETFs on the ASX when needed, with share prices closely reflecting the underlying asset values.
  • Custodian: The custodian holds ETF assets separately from the issuer and administrator, reducing fund manager or counterparty risk, thus safeguarding investors’ funds.
  • Registry: A registry is responsibility for maintaining a register of shareholders.  

ETFs are initially created by large trading firms and institutions. These entities invest money in the underlying index, and the shares in the new investment company (ETF) become available on the secondary market, being the ASX. If an ETF proves popular and attracts substantial investor demand, authorised participants and market makers contribute more funds into the company to make more shares available to meet this demand.

You can find a list of all ETF’s on the ASX website here.

ETFs versus managed funds

ETFs are typically more cost-effective than traditional managed funds due to electronic trading on stock exchanges. Managed funds, with unlisted units, require fund managers to reconcile sellers and buyers daily, incurring higher administration and trading costs. For instance, Vanguards emerging market manage fund costs 0.56% whereas the identical ETF version costs 0.48% p.a.

Bid-ask spreads are the price differences between buyers and sellers, tend to be narrower for ETFs compared to managed funds. This makes it less expensive to invest in or redeem ETFs.

Liquidity, risk, and performance have proven to be manageable concerns when comparing ETFs and managed funds over the past decade. However, not all managed funds are offered as ETFs, as they must reach a critical mass to be attractive to ETF providers.

Some things to look out for

It’s essential for investors to establish an investment philosophy to guide their financial decisions. A philosophy based on principles can help identify ETFs that align with your desired risk and return profile.

If you favour a high-quality, evidence-based approach to investing, it’s advisable to steer clear of thematic ETFs, which invest in specific trends or themes akin to active investing. Mainstream ETFs that track broad indices like the ASX 200, S&P 500, or global indexes are generally more appropriate.

Consider diversified ETFs managed by reputable providers like BetaShares, iShares, and Vanguard, which invest across various sub-asset classes, eliminating the need for constructing a customised ETF portfolio – see list here.

The future of ETFs

While managed funds are unlikely to disappear entirely, ETFs are expected to continue their ascent in popularity. Niche fund managers that lack scale may not offer ETFs, but many established providers are increasingly considering ETF versions of their products. This shift could lead to an even greater adoption of ETFs in the investment landscape.

In conclusion, having a well-rounded investment menu that includes both managed funds and ETFs is essential for constructing a diversified investment portfolio to capture future returns whilst minimising risk. Around half of our clients’ monies are invested in managed funds. However, the continued growth of ETFs may eventually diminish the relevance of traditional managed funds in the future.