I thought that with the current hysteria engulfing the markets, a little perspective on what’s going on might be beneficial.

Australian shares have now officially entered a ‘bear market’ with the major benchmark indices falling more than 20% from their recent highs. The cause of this rapid sell-off has been a combination of economic issues coming out of the US and Europe, including the downgrading of US sovereign debt by ratings agency S&P, downward revisions to US economic growth numbers, and growing fear of the Eurozone sovereign debt issues spreading to Spain and Italy.

There is no doubt that these issues are real, and have potentially serious implications for the speed of global economic growth going forward. But, it is important every now and then to take a step back, and consider once again what it is that we’re actually doing as investors.

When we buy shares in a company, we are purchasing a share in that company’s earnings. And importantly, we’re purchasing a share not only of this year’s earnings, but all future earnings of that company from this day forward. So when we look at any economic issues, it’s always important to relate those issues back to their likely impact on the future earnings capability of that business. The question we need to ask at the moment then, is whether the economic issues that have caused this market sell-off have actually reduced the total future earnings of the businesses that we invest in by 20% or more? If the answer is no, then the decline in share prices may represent a great opportunity to acquire quality companies at more attractive prices than they are usually available at.

Interestingly, when you look at previous periods of severe economic shocks, despite their impact on the level of overall economic activity, many of Australia’s top quality companies saw their earnings continue to grow each and every year. Companies from a diverse range of industries including retailing, healthcare, engineering services, information technology, telecommunications and many, many more grew both their earnings and earnings per share every single year throughout the GFC. Yet, their share prices were not immune – falling by as much as 50% or more in many cases. Smart investors, rather than selling into this panic, used this period as an opportunity to pick up quality stocks at extremely attractive prices.

It’s also worth noting that Australia is far better placed than most other nations to respond to any economic slowdown. Our interest rates are by far the highest in the OECD, which provides the Reserve Bank with significant ammunition to reduce rates and stimulate demand if necessary. If this occurs, it’s highly likely that one of the other major headwinds for Australian businesses of late – the high Australian Dollar – will moderate as well, further improving conditions for domestic companies. Our federal debt is also far lower (at roughly 20% of GDP) than any other major developed nation (the OECD average is around 100%!), meaning that our government still has the option of providing fiscal stimulus if the economy continues to deteriorate. And finally, although our financial markets are still tied closely to Europe and the US, our economy is far more closely tied to the fortunes of Asia than that of the western world. In fact, China is the destination for approximately 25% of our exports, with the US receiving only 4%. In short, while we’re not immune from what’s going on, we are far better placed than most other nations.

So, given all this information, what is the appropriate action? Ultimately, as I don’t know your personal circumstances I’m unable to provide personal advice to you. But there are some general rules that it would be worthwhile paying attention to:

• Don’t panic – Consider the situation rationally, and attempt to determine what impact these economic events are likely to have on the businesses you are invested in.
• Be careful with leverage – Leverage is a double edged sword. While it can maximise your returns in good times, in bad times it can force you to sell at exactly the time when you should be buying. This applies both to personal leverage on your own investment portfolio, but also to leverage employed in the companies you invest in.
• Consider your investment horizon – Anyone with a short-term investment horizon (less than a year) should be especially cautious, as the short term direction of markets is impossible to predict. Investors with a holding period of at least 3-5 years can afford to be more opportunistic, and take advantage of any short term over-reactions in the market.
• Buy quality – If you’re looking to buy shares in this environment, look at companies that have a history of stable earnings, low debt, a solid competitive position, quality management and have preferably shown their ability to survive and even thrive in previous downturns.

And finally, take heed of the words of wisdom of some of history’s greatest investors

“Be fearful when others are greedy, and greedy when others are fearful” – Warren Buffett

“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell” – Sir John Templeton

Good luck, and invest wisely.

Peter Bell
Director

An ETF is a managed fund or unit trust that is quoted and traded on a stock exchange such as the ASX. ETFs are built like managed funds, but trade like shares, meaning that pricing is transparent and that the products can be bought and sold throughout any trading day just like ordinary shares. ETFs generally aim to track as closely as possible the performance of a given index or asset class. They are transparent, liquid, cost-efficient and flexible investment tools – designed to be attractive to both individuals and institutional investors.

ETFs are one of the fastest growing categories of investment products in the world, with over US$1 trillion of assets managed in ETF products globally.

One of the primary reasons for their popularity is that they have all the advantages of stocks, such as being easy to trade and liquid, along with the benefits of index funds, such as diversification and lower costs. With ETFs, it is possible to get a diversified exposure to a large number of securities or an otherwise difficult to access asset class via a single trade and at the same time avoid ‘active manager’ fees.

The Global Market for ETFs

Globally, the market for ETFs has grown exponentially. The graph below shows the growth of the ETF industry in the largest two geographies for ETFs globally, the United States and Europe.

The Australian ETF industry, while comparatively small, has recently grown dramatically. We expect this to continue due to new product innovation and increasing acceptance of ETFs as an asset class in the Australian marketplace

What are the key benefits of ETFs?

Depending on the asset class or index that is being tracked, ETFs can be an ideal long term or short term investment tool. ETFs are widely used globally by both individual and institutional investors.

Simplicity
ETFs help investors gain exposure to a range of investment strategies that can be implemented as simply as buying a share.

Liquidity
ETFs are open-ended funds, meaning the number of units on issue can be increased or decreased in response to daily demand. Units can be bought and sold at any time throughout the trading day. Multiple market makers and Authorised Participants enhance this daily liquidity and provide robust bid-offer spreads. ETFs have similar liquidity characteristics to the underlying shares that comprise the relevant index.

Transparency
ETFs aim to closely track the performance of a specified index or asset class. They have a transparent fund and cost structure. Information on index constituents and assets held by the ETF is published on the issuer websites, giving investors an up-to-date view of the index and assets underlying the ETF.

Cost-effectiveness
Because ETFs aim simply to track the performance of an index or asset class, there are no in-built “active management” fees and ETFs therefore have significantly lower fees than actively managed mutual funds.

How do investors use ETFs?

ETFs can be used by investors for a wide range of investment strategies. Set out below are some of the most common:

Portfolio Construction & Asset Allocation
ETFs can be used as core holdings in a portfolio and as building blocks for portfolio construction. For example, sector ETFs offer diversified exposure to a particular industry sector that could otherwise only be achieved by buying all the stocks in the relevant index.

Core/Satellite Strategy
ETFs are often used in active investment strategies to improve the risk/return of a portfolio. ETFs can be used to build a core portfolio of broadly diversified indices. Single individual stocks can then be added as alpha generating ‘satellites’.

Cash Equitisation
ETFs can be used as a substitute for cash pending individual stock selection. This is used to avoid ‘cash drag’ and as an efficient place to ‘park’ cash while investment decisions are being made.

Pairs Trading
ETFs offer a number of opportunities for pairs trading e.g. going long an index and shorting some of the constituents.

Alternative to Sector Swaps
Investors can use Sector ETFs as an efficient alternative to a sector swap. Using Sector ETFs will mean that investors are not tied to one counterparty for exit and entries and have limited counterparty risk, and they are easier to trade and administer than swaps.

Hedging
Since our products are traded on the ASX, investors can short the ETFs as they would any stock, subject to availability of stock lending.

How to Invest in ETFs

ETFs are traded on the Australian Securities Exchange. As such, they can bought or sold like any share through a stockbroker, financial adviser or online broker. There is no need to open a separate trading account. ETFs can be traded at any time during normal market hours, using all the trading techniques applicable to shares (e.g., market orders, limit orders, stop orders).

Prepared by Betashares

www.betashares.com.au