We assign a ‘performance’ warning label to ETFs and managed funds which we believe will likely produce a return and risk profile that is different to a traditional ETF or fund operating in this sector. This will include most ETFs which uses an active or rules-based approach to investing, such as:
- Yield, value, quality, momentum and growth “factor ETFs”
- Equal weight strategies
- Hedge fund style ETFs
- Multi-asset funds, and
- Ethical ETFs
For example, let’s say you’re comparing two ETFs that you found here on the Best ETFs Australia website. Both of the ETFs operate in the Australian shares sector. So, regardless of which ETF you invest in, you get exposure to the local share market.
However, let’s say ETF #1 uses a rules-based “yield strategy” and only ever buys shares in companies which have high dividend yields. ETF #2 uses a traditional “market capitalisation” or vanilla indexing strategy — that is, for example, it only buys shares in the largest 200 or 300 companies on the market. Broadly, here’s what our team at Best ETFs Australia expect you will get from your investment:
- Yield strategy (ETF #1) –– with this ETF you’ll get exposure to a portfolio of dividend-paying Australian stocks/shares. The dividend or ‘historical yield’ on this ETF will look higher than ETF #2 and it’ll probably have fewer stocks inside the portfolio because not every share pays a dividend. The companies inside the ETF are giving up some of their profits that could be reinvested in the business.
- Traditional market cap strategy (ETF #2) — with this ETF you will get all of the largest shares in the, for example, top 200. Some will pay dividends back to shareholders and some won’t pay dividends. In our opinion, the most likely reason a large company will not pay a dividend is because they want to keep that cash inside the company for growth and new projects. Typically, this leads to more profit and the companies can grow faster.
- The difference. Ultimately, the difference between the two ETFs is how you get your returns and impact that has on your wealth in the long run. You might like an ETF to pay a regular dividend. But if you’re a long-term investor (5-10+ years or more) you might find that the ETF which pays higher dividends (ETF #1) is sacrificing growth and might actually be going backward! Please take another look at the image above. It shows a simplified example of the potential trade-off. Of course, some ETFs can pay dividends and grow over time. We’re taking a generalised approach.
Our take: don’t be fooled by every ETF and fund that claims to provide a ‘differentiated’ approach to investing. There’s no secret formula. Every investment has risks.