NZX splashes on extra exchange-traded funds

By Michael Coote

Friday 20th August 2004

The New Zealand Exchange has made a big splash of launching new exchange-traded funds (ETFs).

These funds are passive replicas of capitalisation-weighted sharemarket indices and can have tax benefits in respect of capital gains because they simply buy-and-hold component shares rather than actively trading them.

In reality, ETFs are nothing new on the local sharemarket. In its old NZSE days, the exchange kicked off first with the TeNZ fund, a New Zealand top ten index tracker it still offers.

At one point the exchange tried to sell out of the TeNZ management contract, so there must have been some doubts along the way.

Other competitors followed suit, AMP launching its WiNZ global fund, Tower its Tortis Ozzy Australian top 20 fund, and ABN Amro Craigs its NZ Mid Cap Index Fund.

With new-found enthusiasm the NZX has decided to go down the path of offering more ETFs.

It has taken over the ABN Amro Craigs product, acquired the rights to an ASX mid-cap tracker fund, and intends to put out an NZX top 50 fund.

The sales pitch goes that the NZX's ETFs will enable low-cost access to baskets of shares for the ordinary punter to make long-term investments in.

Annual management fees are touted as being below 0.75%, but in the US these fees go as low as 0.1% 0.2%.

The Americans introduced ETFs over a decade ago, where $US178 billion is now invested.

Japan has built up a big market of its own, worth about $US30 billion, and there is a chunky European market traded out of the Frankfurt exchange.

The first Chinese ETF based on the Shanghai 50 Index is to be listed by year end.

Rapid rise this year to date in funds influx into these products disguises the fact that in the US ETFs still make up only 3% of the $US 7.5 trillion mutual funds market.

The Economist recently reported that ETFs have been recycled worldwide as the latest fashionable investment products.

Their big appeal over traditional managed funds is that they can be freely traded throughout the day.

Rather than use for long-term investment, ETFs have become hot property for day traders and technical analysts who thrive on the churn 'em and burn 'em school.

Strong market liquidity is presupposed to make this trading approach work.

ETFs can often be short-sold in overseas sharemarkets, which has made them popular with hedge fund managers a nd also conventional managed funds barred from using derivatives.

Typically, locally offered ETFs have IRD binding rulings making capital gains non-taxable in the fund. Investors can get this benefit passed through, but only if they are not asset traders themselves. For traders the tax advantage disappears.

Another quirk of ETFs with IRD binding rulings is that they cannot use tax losses to smooth out the inevitable downturns.

Accordingly when the 2000-3 bear market took hold, ETFs affected were hit hard in following their base indices south and lacked any tax assets to carry forward thereafter.

In the meantime, as passive funds they could not sell shares, switch into cash, or buy into other assets to mitigate the crash and took the full hit.

New Zealand dollar exchange rate fluctuations can also squash returns on ETFs that invest unhedged in foreign shares.

As noted, technical traders like ETFs. The reason is that the underlying indices are easily graphed and analysed for turning points in market sentiment.

If short-selling is thrown in as well, traders can play the market both ways; up or down.

The trick for the NZX will be to find enough players to squeeze some life out of the ETF fad, and that will depend on how liquid the market is: very much a chicken-and-egg problem.

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