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ETF Core Strategies

Aim: To trend-trade general equity ETFs so as to ride rallies and buck busts in the Australian share market.

ETF Rotation Strategies

Aim: To back the local and foreign sector ETFs with the strongest price gains over both short and long terms.

What are Exchange Traded Funds (ETFs)?

There are three exchange traded funds (ETFs) suitable for timing the wider Australian share market. They are:

  1. State Street Global Advisers, Australia Services Ltd – SPDR S&P/ASX 200 Fund (ASX share code STW)
  2. Vanguard Investments Australia Ltd – Australian Shares Index Fund (code VAS)
  3. State Street Global Advisers, Australia Services Ltd – SPDR S&P/ ASX 50 Fund (code SFY)

In addition there are high yielding ETFs that move in sympathy with the wider market so may also be suitable for timing using our signals. They are:

  • Russell Investments –  High Dividend Australian Share ETF (code RDV)
  • State Street Global Advisers –  SPDR MSCI Australia Select High Dividend ETF (SYI)
  • Vanguard –  Australian Shares High Yield ETF (VHY)
  • iShares – S&P/ASX High Dividend ETF (IHD)

An ETF is simply an investment fund traded on the stock exchange, much like other stocks. Each of the ETFs above hold shares that mirror an Australian stock market index (like the S&P/ASX 200 index which is an index of the top 200 Australian shares by market capitalisation). An ETF trades at approximately the same price as the unit net value of its underlying assets over the course of the trading day.

ETFs have unique benefits, especially for timing the Australian share market. The eight most important are discussed below:

1. Correlation

Movements in the market prices of each of the above ETFs, though based on stock indices with as few as 50 shares, closely track the changes in the All Ordinaries Index. The All Ords Index reflects the value of the largest 500 companies listed on the ASX which together account for over 95% of the value of the 2000 or so companies listed on the ASX. This can be seen in the next chart which shows the (blue) closing daily prices of the SPDR S&P/ ASX 50 Fund (code SFY) compared with the (red) daily closing values of the All Ords Index over the last year. Notice how closely they match. More importantly note that when the All Ords index tops or bottoms so does SFY even though the latter covers only one tenth the number of shares included in the former. That’s because SFY still represents 69% of the market worth of the All Ords Index. The SPDR S&P/ASX 200 Fund (ASX share code STW) and the Vanguard Australian Shares Index Fund (code VAS) represent 83% and 85% respectively of the All Ords Index. Not surprisingly they hug the All Ords Index even more closely than than the SPDR S&P/ ASX 50 Fund. The smaller companies whose shares aren’t included in the recognised share indices largely respect the market trend set by the big to medium sized firms which is why the indices provide such a good proxy for the share market as a whole.

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2. Diversification

EFTs enable you to diversify your portfolio through holding a single security. Diversification is critical to minimising risk exposure to a specific stock (e.g. ABC Learning). The SPDR S&P/ASX 200 Fund (STW) holds Australia’s top 200 listed companies so is well diversified notwithstanding only the top five shares in the fund’s portfolio (BHP Billiton, CBA, Westpac, ANZ Bank and NAB Bank) each constitute 5% or more of the total asset value. The next five shares (Wesfarmers, Woolworths, Telstra, Rio Tinto and Westfield) which are also blue chips each constitute around 3% of the funds total value. The remaining 190 shares each average only 0.25% of the Funds total value. This means that unless one of the top five blue-chips goes bust (which is very unlikely), the impairment to the fund of any of the other companies collapsing would at most be 3% and typically about 0.25%. Research shows that a portfolio needs at least 30 to 40 shares from separate companies spread across most industry sectors to minimise specific stock risk. Each of the four ETFs reviewed here pass that test.

3. Convenience

Many people buy between 10 and 30 shares trying to beat the market. Yet active funds managers that employ large teams of professional stock analysts struggle to achieve that outcome. According to Wikipedia’s rundown on mutual funds, empirical evidence suggests that actively managed mutual funds under-perform indexed funds. One study found that nearly 1,500 U.S. mutual funds under-performed the market in approximately half of the years between 1962 and 1992. Moreover, funds that performed well in the past were not able to beat the market indefinitely. In Australia wholesale funds managers have on average beaten the index by about 1.5% per annum over the last ten years, but after allowing for the 1.5% to 2.5% margins charged by the funds retailers the end result is on par with low cost passively managed indexed funds. If most actively managed funds can’t beat the index after expense why should the average investor think they can do better? Research shows that asset allocation (e.g. switching between shares and cash) is far more important than stock selection (e.g. choosing BHP Billiton over Rio Tinto) for achieving high returns. Indeed most investors perform poorly in the share market because they do neither task well.

DALBAR, a North American financial services research group, found that for the twenty years to the end of 2011,the average American investor in an equity mutual fund under-performed the S&P 500 Index by an annualized 4.3% per year. The S&P 500 returned an average of 7.8% a year, but the average equity fund investor generated only 3.5% per year. If the same investors had simply bought and held an ETF that replicated the S&P500 (e.g. SPDR S&P 500 SPY) they would have had an annual return of 7.7% after fees. If they had used the ETF to time the market using the signals of a reliable timing service they would have done better still. TimerTrac which tracks the performance of market timers who have agreed to be audited shows that four out of five timing strategies issuing ‘equity long only’ signals outperformed the S&P500 over the five years to June 2012. Buying a stake in the wider share market through a single ETF not only makes more sense than selecting and managing your own share portfolio, but also requires less time and paperwork.

4. Flexibility

Because an ETF is a traded security it enables you to enter and exit the market at any time between 10am and 4pm on a trading day. This can be done by phoning your discount broker or more cheaply by using an online broking account. By comparison an unlisted managed fund, whether active or passive, will at best let you buy or sell its units at their closing price on the day you notify them. Most require two to three days notification before they strike a price for your units. By then it might be too late to profit from the signal change unless you are using the Conservative strategy which times only long term market trends. Also units in unlisted funds can’t be bought or redeemed over the internet like an ETF since they require signed documents to be lodged with their responsible entities. Another disadvantage is that unlisted managed funds maintain a wide buy/sell spread to cover the administrative costs of increasing or reducing their security holdings to match their unit holdings. By contrast shares in an ETF can switch ownership without requiring any change to its portfolio.

5. Liquidity

As ETFs have become more popular their daily trading volume has increased substantially. The market capitalisation of all Australian ETFs rose from $500 billion in June 2004 to over $5,000 billion by June 2012, a tenfold increase in just eight years. Arbitragers and/or market makers ensure that ETF market prices don’t stray too far from the value of their underlying indices. For some ETFs (e.g. STW, SFY, SYI and RDV) simply inserting the letter Y before its ASX code will show its indicative net asset value (NAV) so you can check whether the security’s market price is trading at a premium or discount to its underlying asset value. You can try this on http://au.finance.yahoo.com/ by bringing up the All Ords index chart and then entering the symbol of an ETF (e.g. STW.AX) next to ‘Get Chart’ and under ‘Compare’ entering its indicative NAV (e.g. YSTW.AX). Discrepancies of around 0.5% are not unusual because the Australian ETF market is not as liquid as its American counterpart notwithstanding certain brokers being paid by the ASX to provide an ongoing market in ETF securities within an a maximum spread between their quoted prices and their underlying value. If arbitragers become more active as they are in America such spreads should largely disappear. The most liquid ETF in Australia is STW, which has a daily turnover of about $300 million, which is why it’s our preferred security for timing the Australian share market.

6. Cost

Being indexed, ETFs don’t have high cost overheads. Hence their management costs are only a fraction of the 1.5% to 2.5% typically charged by actively managed retail funds. Annual management fees relative to fund net assets are 0.27% for VAS, 0.286% for STW and SFY and 0.46% for RDV. Of course ETFs incur (discount) brokerage fees as low as 0.1% per trade for large transactions (i.e. in excess of $10,000). That comes to around 0.20% per annum for MarketTiming’s Conservative Strategy (which on average trades about twice a year). The published performance comparisons of our strategies against buy and hold already take account of a typical online brokerage cost of 0.12% per trade.

7. Distributions

ETFs accrue dividends from the underlying securities in their portfolio. These are distributed net of management expenses to unit holders either half yearly (STW and SFY) or quarterly (VAS and RDV). In the four to six weeks preceding a distribution the ETF’s market price will run ahead of its underlying index (though not its underlying asset value) before coming back into line with the index after its ex-dividend date. The returns of Russell’s High Dividend Australian Shares ETF are designed to track the performance of the Russell index by the same name. That index focuses on the 50 highest dividend paying shares of the 100 largest stocks on the ASX. Its goal is to produce a yield 1% higher than the market. Typically the average dividend payout for the All Ords Index is around 4%. Don’t be alarmed if you get a MarketTiming Sell signal for an ETF just before its ex-dividend date since its market price will already reflect the accumulated dividends up to the sale date. That’s why an ETF’s price always get ahead of its underlying index value (but not necessarily its indicative portfolio value which includes accrued dividends) in the lead up to its ex-dividend date, but then falls back to its index value immediately after that date (when the dividends in the ETF’s share portfolio are notionally set aside for its owners on that date).

8. Taxation

An ETF will change in value as its underlying portfolio of shares changes in value. It makes distributions with franking credits. ETFs have a low turnover of stocks because as long as they grow in size the only shares sold from their portfolios are those dropped or downgraded in their underlying indices when they are periodically rebalanced.

This means indexed funds incur little capital gains or losses if held indefinitely. By contrast actively managed equity funds (whether listed or unlisted) typically turnover their portfolios at least once a year thereby incurring capital gains or losses. That’s why distributions by ETFs are usually subject to much lower capital gains tax than those of actively managed funds.
When shares in an ETF are sold they generate either capital gains or losses.

According to Wikipedia:

Capital gains tax (CGT) operates by having net gains treated as taxable income in the tax year an asset (such as an ETF share) is sold or otherwise disposed of. If an asset is held for at least 1 year then any gain is first discounted by 50% for individual taxpayers and some trusts, or by 33.3% for superannuation funds. Net losses in a tax year may be carried forward, but not offset against income…

It should be noted that the amount left after applying the CGT discount is added to the assessable income of the taxpayer (individual, company or superannuation fund) for that financial year.

The 20120/131 marginal personal tax rate is 45% on income over $180,000, 37% on income between $80,001 and $180,000 and 32.50% on income of $37,001 to $80,000. Income under $18,200 is exempt from tax. These rates do not include the Medicare Levy of 1.5% for those with private health insurance or the 2.5% Medicare Surcharge for those without such insurance.

The tax on superannuation income is a flat rate of 15% on accumulation accounts and zero on pension accounts, which is why investing or trading in shares (including ETFs) is so attractive within a superannuation context.

For tax purposes an individual or company (but not a super fund) needs to determine whether they fall into the category of a share trader or not. For further information on this check out Wikipedia (http://en.wikipedia.org/wiki/Capital_gains_tax_in_Australia) and the Australian Tax Office guidelines (http://www.ato.gov.au/businesses/content.asp?doc=/content/21749.htm) and speak to an accountant.
Because the Conservative Strategies usually issue at least one sell signal within a financial year any capital gains arising from transactions based on these strategies will normally not be eligible for a concessional rate of tax (check with your tax adviser). But within a super fund any trading strategy is tax effective because of the low or zero rates that apply to capital gains even when shares (e.g. ETFs) are sold within a 12 month period.

Conclusion

Of the four ETFs most suitable for market timing, the closest correlation to the All Ords Index at the end of a trading day has been SFY, VAS, STW and RDV in that order. Except for RDV these differences are not that material.

More important is that STW has about 80% of the market turnover of the four ETFs. That’s why it relies less on a market maker to keep its price in line with its underlying index.

RDV like other high yielding dividend ETFs (such as SYI, VHY and IHD) is trying to appeal to investors by aiming to pay an annual dividend yield 1% above the market’s average yield of roundly 4%.

This review of ETFs suitable for timing the Australian share market is meant for educational purposes only. You should acquaint yourself with the benefits and risks of any ETF you use by reading its Product Disclosure Statement (PDS). This can be obtained from the website of its responsible entity.

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