Advisers are concerned about the sustainability of too-cheap-to-be true exchange-traded funds following a year in which ETF issuers were in a race to the bottom for fees, however, pressure on costs is helping ETFs grab market share from managed funds.

Senior financial adviser Tony Davison is concerned fees on some ETFs that are virtually no cost are worryingly low.

“How sustainable is a product if the issuer doesn't make a margin on it? Although ETF costs are still high for newer, more nuanced ETFs,” he says.

Davison argues there is a point at which lower costs are less relevant than the value the issuer can add, as well as investor confidence the ETF will stay the course.

“So while ETF cost is a driving factor in portfolio construction, a reasonable price should be paid for their issuance and construction.”

Director of professional services firm Asparq Scott Fisher says the race to the bottom seen in fees for traditional ETFs is likely to put a lid on fees for active ETFs.

Investors are expecting a rush of these structures to hit the market after regulator the Australian Securities and Investments Commission (ASIC) lifted a ban on them late last year.

“Active managers must not price themselves out of the ETF market. They must also be careful they do not undercut their existing managed funds business. They might be able to offer a 0.10% fee reduction on the ETF version of a managed fund product. But if they charge 1.2% for a managed fund they cannot charge 0.75% for the ETF.”

Asset allocation shifts

Following a strong year for equities in 2020, advisers are now rethinking clients’ asset allocation

“Growth exposures are now much higher than the target. You might have a 60% target for an equities allocation in a balanced or growth portfolio. But the actual allocation might be at 70% shares,” Fisher says.

“Thanks to the strength of the market in 2019, now might be the time to look at rebalancing assets. This might mean selling down a portion of the equity component of your ETF investments and reinvesting in fixed interest or cash,” he adds.

This year investors are also looking to newer ETFs to skew their portfolios. Funds that give investors exposure to themes they cannot easily access themselves such as banking, tech, factor investing or different geographies like Asia or the US should be popular. New issues should also be prolific.

Watch your back

Turning to risks, liquidity as well as large buy-sell spreads, particularly for exotic ETFs, remain issues in the market.

“But advisers and brokers can usually open up more volume. If the trade is sizeable, they can talk directly to the market maker, which can often provide more liquidity,” Fisher says.

Davison argues investors do not pay enough attention to liquidity. “ETFs can mask illiquidity in underlying assets. The risk is investors may not be able to sell the ETF when they want to as the issuer has to sell the underlying ETF assets.”

It is advisable for investors to investigate the underlying liquidity of the assets within the ETF before tipping money into it. “There is a risk you will not be able to sell your ETF before everyone else if the assets trade by appointment and everyone wants to sell at the same time,” he adds.

It is important to research the issuer’s viability and the market-making capability in the product to ensure the ETF’s liquidity.

Davison says: “Liquidity has evaporated in some situations where underlying indexes have moved substantially or if the index has been adjusted.

“This means the ETF also needs to be adjusted, which is difficult if it is a significant investor in the underlying shares.” US inverse volatility ETFs are an example where this has been a problem.

Commenting on market makers’ stability, Fisher adds: “A credit or financial crisis that forces the major market makers to withdraw would have repercussions.”

Time to trade

Advisers suggest trading ETFs between 10:30 am and 3:30 pm when markets are most efficient.

“We do not want to buy the index at 10:05 am when only some of the underlying stocks have opened for the day. It can get tricky for international ETFs when the physical market is closed; the ETF price tends to be led by the futures market,” Fisher explains.

An important dynamic to consider as investors turn their attentions to ETFs with international exposures to diversify their portfolios.