Passive investing an untapped opportunity

The government wants mum-and-dad investors to dig into their pockets and buy shares in state owned electricity company Mighty River Power when it lists on the NZX.

For many it will be the first time they have directly put money into the sharemarket, sparking dinner table debates around the country on whether it's a good investment.

At this stage, with many of the fine details still under wraps, the answer to that is unclear.

But it has raised a question among financial advisers about why first time investors are even considering putting all their eggs in one basket when there might be better-suited vehicles out there for their hard-earned dosh.

Exchange Traded Funds are one such vehicle. Despite their technical-sounding name, they provide an ideal way for retail investors to get a low-cost, low-risk exposure to an exhaustive list of assets classes ranging from shares in companies to commodities.

The most popular way for these funds to do this is by selecting a benchmark - say the NZX50 Index - and then proportionately buying shares in that index so that all the assets of the fund exactly match the weighted composition of the index. Put another way, if Telecom makes up about 1.4 per cent of the NZX50, then 1.4 per cent of an ETFs funds will be invested in Telecom stock.

The ETF is then listed on a stock market where the units are bought and sold, hence the "exchange traded" part of the name.

The advantage of ETFs is that they cover the two must-haves of any good investment strategy: cost effectiveness and diversification.

They're cost effective because their simple investment strategy means they don't hire teams of finance specialists, and they don't rack up the brokerage costs seen with active investment strategies because they don't constantly buy in and out of stocks.

Equity index rankings are normally reviewed on a quarterly basis, which is when ETFs adjust their asset mix.

That means annual fees are extremely low, anywhere between 0.2 per cent and 0.8 per cent of funds under management compared to 1 per cent to upwards of 5 per cent for managed funds.

Secondly, because ETF investors are effectively buying a piece of every company on the stock exchange they automatically spread the risk of individual stock volatility.

Here's a simple scenario to show how that works:

Say you invested $2000 in Company-X, and after a bad year, the stock dropped 20 per cent in value. It would leave you $400 out of pocket.

But if you invested the same amount via an EFT, and Company-X made up 10 per cent of the fund, then your loss would be $40.

Certainly the flipside is also true.

Company-X could have reported a 20 per cent gain, in which case an ETF would only have earned enough to buy a couple of drinks - but at least you would have kept your shirt, and that has to be a comfort for newbies getting into equity investing.

Yet despite all these advantages ETFs are an almost unheard of as an asset class in New Zealand.

According to figures from Smartshares, an NZX subsidiary which operates three domestic and two Australian ETFs, it had a total of $289 million in funds under management as of June 30. Actively managed funds by comparison had $25.9 billion under management.

Smartshares' ETFs represent about 0.5 per cent of the NZX's $57 billion market capitalisation. That's pretty dismal compared to the US and Germany where they account for between 7 and 8 per cent.

So why are Kiwis neglecting passive investments?

It's probably because they've never heard of them, says Sam Stanley, the newly appointed head of Smartshares, who is making it his mission to revive the flagging asset class.

"I talked to a broker the other day and he said 'you guys should get into ETFs' and I actually had to tell him we have five of them," he said.

That lack of profile has resulted in Smartshares' funds under management falling 15 per cent in the year to June 30.

It also has the effect of decreasing their cost competitiveness versus managed funds, with Smartshares ETF fees positioned at the upper end of price band at about 0.75 per cent.

"One of the key positive features of an ETF is the cost, and [in New Zealand] they're not overly cheap," said Chris Douglas, co-head of fund research at Morning Star. "If you look at Australia you could be paying (0.15 per cent to 0.2 per cent) to access an Australian ETF."

That helps explain the perceived bias some brokers and advisers have for actively managed funds. But some of the responsibility also has to rest with investors themselves.

Ben Brinkerhoff, general manager at financial advisory firm Bradley Nuttall, said the low level of financial literacy in New Zealand means mum-and-dad investors are more likely to base their investments on the excitement surrounding Mighty River Power's IPO rather than looking for diversification and low fees.

"Investing should be like watching grass growing," he said. "If you want excitement, go to Las Vegas."

Stanley, who has only been in the Smartshares job for about a month, says raising the profile of the funds is one of his main priorities, although the charm offensive is likely to focus on brokers and institutional investors rather than less sophisticated punters.

Any changes will probably take a while to filter through but that shouldn't stop retail investors from discussing ETFs with their financial adviser and seeing how they fit within their portfolio structure.

After all, who says you can't invest in ETFs and buy Mighty River Power shares as well?