ETF Basic Questions

Hi Everyone
I'm looking at investing in some ETFs but a couple of things got me a bit confused. I've gone back about 2 years but couldn't find the answers so thought I would post the questions here.

* Diversification - I have been told that ETF's are a great way to diversify your portfolio, but looking into a couple of them, there seems to not be as much diversification as I thought there might be. EG1 Smartshares ASF has a quarter of it's holdings in a single share. EG2 Smartshares EMF (Vanguard VWO) one of the top ten holdings main business is holding an investment in another of the top 10 holdings "investment in Tencent also appears to be the main driver of the value of its own stock, and has since overshadowed the operational aspects of the Naspers business" - So my question, How do ETF's decide what shares to buy at what proportion? How often does this change?

*Fees - Most of the Smartshare ETF's I've looked at have a single holding - a Vanguard ETF, which charges normally about .05% in fees. Smartshares are charging ~ .5% in fees in most cases, so about 10 times that amount. Am I missing some fees or something out? Is there a better way to buy Vanguard ETF's which has a lower spread on the charges?

*Fees again, If you were looking at a longer term holding with a higher amount of money - wouldn't you be much better off just buying the same basket of shares at the same proportion instead of through the ETF? I'm more meaning for something like the NPF Local property fund which only has 8 holdings

* Foreign exchange risk / hedge - One of the main reasons I'm interested in foreign ETF's is (I think) a way to hedge the risk investing in the NZ economy. This seems to me like it would be a large driver for the price of an overseas etfs, but I haven't seen it mentioned much. when the NZ economy cycles downwards then money flows out of NZ and the dollar drops, making the ETF more valuable, correct? But I have also heard when the US economy tanks that investors get spooked and pull their money back? Can someone explain this part of ETF investment a bit better, especially from the view of a very small economy VS big ones.

I'm sorry for all the questions, and have enjoyed reading up on your previous comments!

There's a lot to answer so it will be hard to keep it down to a short message:

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* Diversification

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You may be missing the details of the individual shares being held. That is for eg. the Vanguard shares are already a diversified holding of many many different shares in that index. So these ETFs you're looking at may have the bulk of the $ in a widely diversified stock such as Vanguard.

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*Fees

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The main difference is due to economies of scale. Naturally Vanguard is among the lowest in the industry as Jack Bogel (RIP) had pioneered the low cost ETF system. Anyone else that is trying to replicate his model won't do so because they're not big enough. None of the NZ funds like in Kiwi Saver will come close to this 0.03% p.a. management fee. When a private hedge fund tries to duplicate the same returns of an index, it cost them $ to allocate certain portions of the funds to each holding, it's a lot of paperwork on a daily basis and these trade / holding data much be held perpetual.

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*Fees again,

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Again, it's not likely other ETFs will produce a better return when you factor the higher fees they charge. What makes ETFs unique than yourself trying to buy each individual stock in the index is they have re-balance mechanisms in play. For eg. take the S&P500 index which is the top 500 performing stocks. Periodically 1 or 2 stocks gets bumped off (ie General Electric) and to be replaced by an up an new rising stock (Walgreens ; pharmacy). The ETF managers would require to sell off the GE holding and buy the new Walgreen stock. As an individual, if you're not watching day by day and keep up with the finance, you may never know and end up with what you though as having a diversified index but actually holding a risky holding of stocks.

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* Foreign exchange risk / hedge

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Historically the NZX has performed a lot less than the US market. The reality is that if you want diversification, you just can't hold NZ listed shares because for the level of return for the risk you take is really not wise investing. I studied finance in Canada and the Canadian equity market only accounts for a whopping 3% of the GLOBAL investing market. It's like walking into a grocery store and picking only 1 shelf out of all the isles you can look to buy. This is not wise.

The 2nd problem is NZ's FIF tax rules by IRD. You have a $50K NZD threshold for overseas investments in shares. Once you go over that amount, then you trigger a lot of tax issues, complicated filing ($ for the accountants each year to organise your tax return). etc. and in this day of age $50K is not a lot of money. The FIF is a tax on paper gains (without addressing tax credit on years where you go negative). So you can easily have a situation where you've paid no tax on the years you've lost, but then when you rebound back, IRD taxes up to 5% of the gain for the years where you go back positive. It's like climbing an uphill battle. Some NZ financial advisors say the 5% FIF tax is small... but then explain why Jack Bogle has been so against on high management fees (or taxation) of the account? It's because to get the maximum impact for a retirement account, you need tax free compounding (just like the capital gains on houses in NZ have grow tax free for the past... 40 years?). I'm quite certain the formation of the FIF was geared to lock down NZ investors to choose in favour of Kiwi Saver. The start reality is Kiwi Saver may be less than 0.1% of the global investment options.

As for USD exchange rates go. Again, the world will move on if the NZ economy takes a dump. But if the US economy heads into recession, then the WHOLE world will be affected. On a macro level, you're best to hold USD currency as the direction of socialist nations like NZ is to raise taxes (ie Carbon taxation) which will erode the standard of living. Places like in the US that have lowered taxes and regulation will prosper more having a strong USD currency. It's also the reason why the NZD currency always pays a higher interest rate than USD (because of the higher risk holding the NZD).

Hi SBQ
Thankyou for your reply, I know it must have taken more than a couple of minutes to write and I appreciate that.
As it happens I got overly eager and invested in a few ETF's before seeing your post, which actually answered some of my questions anyway, but also generated a couple of more questions.

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Originally Posted by SBQ

There's a lot to answer so it will be hard to keep it down to a short message:



You may be missing the details of the individual shares being held. That is for eg. the Vanguard shares are already a diversified holding of many many different shares in that index. So these ETFs you're looking at may have the bulk of the $ in a widely diversified stock such as Vanguard. Yes and no, I guess my question was more of how ETF's can be seen by new investors (such as myself) as a magic diversification bullet, but I was surprised to see for instance Smartshares ASF being comprised 25% by Commonwealth Bank Australia. If that one share does badly then the whole ETF will suffer. My other example, EMF is 100% VWO from Vanguard, is not as extreme but did appear to have a surprising (for me) lean toward the Chinese market, with only 2 of the biggest 10 holdings not being primarily Chinese. If I had bothered to scroll down the page I would have seen that ~50% of the ETF is invested in China and Taiwan.



The main difference is due to economies of scale. Naturally Vanguard is among the lowest in the industry as Jack Bogel (RIP) had pioneered the low cost ETF system. Anyone else that is trying to replicate his model won't do so because they're not big enough. None of the NZ funds like in Kiwi Saver will come close to this 0.03% p.a. management fee. When a private hedge fund tries to duplicate the same returns of an index, it cost them $ to allocate certain portions of the funds to each holding, it's a lot of paperwork on a daily basis and these trade / holding data much be held perpetual. My Point is more that for ~.45% margin Smartshares makes a single share (Vanguard) purchase per ETF per month (for their offshore ETF's), which appears to be a rort, but may be taken up with compliance costs. I thought this was the only realistic option for me as an NZ investor, however I have since seen that I can buy iShares through ASB securities, I have not yet investigated this yet, including whether or not there is effectively a 50k (tax) limit to what I can invest.



Again, it's not likely other ETFs will produce a better return when you factor the higher fees they charge. What makes ETFs unique than yourself trying to buy each individual stock in the index is they have re-balance mechanisms in play. For eg. take the S&P500 index which is the top 500 performing stocks. Periodically 1 or 2 stocks gets bumped off (ie General Electric) and to be replaced by an up an new rising stock (Walgreens ; pharmacy). The ETF managers would require to sell off the GE holding and buy the new Walgreen stock. As an individual, if you're not watching day by day and keep up with the finance, you may never know and end up with what you though as having a diversified index but actually holding a risky holding of stocksh As it happens, I had intended on buying individual shares to emulate the NPF etf, but when it came to it I realised I would need to spend $30 per share * 8 shares = $240 to buy (and sell I presume - haha haven't got that far) Given I am not looking for a very long term holding nor a very large holding, the yearly .5% was not a huge price to pay, especially if I need to get the money out in a hurry.



Historically the NZX has performed a lot less than the US market. The reality is that if you want diversification, you just can't hold NZ listed shares because for the level of return for the risk you take is really not wise investing. I studied finance in Canada and the Canadian equity market only accounts for a whopping 3% of the GLOBAL investing market. It's like walking into a grocery store and picking only 1 shelf out of all the isles you can look to buy. This is not wise.

The 2nd problem is NZ's FIF tax rules by IRD. You have a $50K NZD threshold for overseas investments in shares. Once you go over that amount, then you trigger a lot of tax issues, complicated filing ($ for the accountants each year to organise your tax return). etc. and in this day of age $50K is not a lot of money. The FIF is a tax on paper gains (without addressing tax credit on years where you go negative). So you can easily have a situation where you've paid no tax on the years you've lost, but then when you rebound back, IRD taxes up to 5% of the gain for the years where you go back positive. It's like climbing an uphill battle. Some NZ financial advisors say the 5% FIF tax is small... but then explain why Jack Bogle has been so against on high management fees (or taxation) of the account? It's because to get the maximum impact for a retirement account, you need tax free compounding (just like the capital gains on houses in NZ have grow tax free for the past... 40 years?). I'm quite certain the formation of the FIF was geared to lock down NZ investors to choose in favour of Kiwi Saver. The start reality is Kiwi Saver may be less than 0.1% of the global investment optionsrOR Foreign ETF's? I take it we can invest more than $50k in an NZ based (Smartshares) ETF investing in overseas investments without further tax problems?

As for USD exchange rates go. Again, the world will move on if the NZ economy takes a dump. But if the US economy heads into recession, then the WHOLE world will be affected. On a macro level, you're best to hold USD currency as the direction of socialist nations like NZ is to raise taxes (ie Carbon taxation) which will erode the standard of living. Places like in the US that have lowered taxes and regulation will prosper more having a strong USD currency. It's also the reason why the NZD currency always pays a higher interest rate than USD (because of the higher risk holding the NZD)On some other advice I have been given I have started looking seriously at Gold as an investment option also. incidently also through an ETF although I have not decided which one - as far as I can see there is no NZ based Gold ETF, and I might be near the $50k limit for foreign investment. One other thing I did notice was that during the GFC, the NZD did take a dive at about the same time as some of the Vanguard ETF's which I looked at did, which I believe the net effect of which would be to reduce the losses for an NZ based ETF

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My other new question is more specific to the Smartshares which I bought. On the market there is a split between buy and sell, as is for all shares, giving a possible small loss as margin during the buying and selling process. The other option is to buy the ETF straight from Smartshares which occurs once per month. Therefore, is there a financial advantage in doing the second option? Can the amount be estimated?
Thanks again

A great response SBQ and very kind of you to take the time to answer in such detail. Prettu much sums up why I have a regular monthly investment in Smartshares US500

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Yes and no, I guess my question was more of how ETF's can be seen by new investors (such as myself) as a magic diversification bullet, but I was surprised to see for instance Smartshares ASF being comprised 25% by Commonwealth Bank Australia. If that one share does badly then the whole ETF will suffer. My other example, EMF is 100% VWO from Vanguard, is not as extreme but did appear to have a surprising (for me) lean toward the Chinese market, with only 2 of the biggest 10 holdings not being primarily Chinese. If I had bothered to scroll down the page I would have seen that ~50% of the ETF is invested in China and Taiwan.

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ETFs are not a magic bullet. When it comes to investing, nothing is a magic bullet, even owning a house. The reason the VWO is highly invested in Chinese / Asian stocks is due to the type of ETF, hence "Emerging Market". The investor needs to be aware of what area they want their $ put in. Any large % weight allocated to the EFT should be balanced based on 'market size' of the stock. So if you see something like 25% of the ETF is Commonwealth Bank of Australia - that may be perhap that ETF is focused on a certain sector (banks?) and the value of that stock represents an equally weighted proportion of the index it trades in. They're not taking say $1000 and equally dividing it up to buy every stock in the index of same value, it's proportion to the market cap size of each stock and at the end of each day, the ETF has to 'rebalance' the portions so not 1 single stock becomes more riskier than the other.

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... I have not yet investigated this yet, including whether or not there is effectively a 50k (tax) limit to what I can invest.

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There won't be. The FIF rules mainly apply to individuals that DIRECTLY hold overseas stocks (exception of some ASX listings). Such as having a discount brokerage account in the US where you directly buy the Vanguard ETF in your name. The reason is the FIF is suppose to regulate individuals away from doing direct investing and channeling them through to invest in local, NZ funds ; after all (and correct me if i'm wrong) it was Bill English that formulated the Kiwi Saver and introduced the FIF tax laws in order to get Kiwi Saver going. The NZ funds themselves in ETF or managed / hedge form operate the investments in 2 ways. Either PIR (Prescribed Investor Rate) or solo where the fund pays a flat rate 28% tax. The PIR is suppose to give the low income investors an advantage be being taxed at the lower bracket. I'm not a fan of this way of investing and personally, the NZ Super pension fund could do a far better job for the NZ citizen by directly buying the ETF as it does not have to deal with paper work and paying ANNUAL TAXATION on the gains. This is why Jacinda Ardern is so fired up about investors owning rental properties because they can long term pay no capital gains tax.

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OR Foreign ETF's? I take it we can invest more than $50k in an NZ based (Smartshares) ETF investing in overseas investments without further tax problems?

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Correct as I mentioned before. Smartshares would end up paying taxes on the paper gains.

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)On some other advice I have been given I have started looking seriously at Gold as an investment option also. incidently also through an ETF although I have not decided which one - as far as I can see there is no NZ based Gold ETF, and I might be near the $50k limit for foreign investment. One other thing I did notice was that during the GFC, the NZD did take a dive at about the same time as some of the Vanguard ETF's which I looked at did, which I believe the net effect of which would be to reduce the losses for an NZ based ETF

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At Warren Buffet's said in his 2018 annual meeting, gold will never have the return of a productive asset. https://www.youtube.com/watch?v=tVutQfL3XdU
Generally speaking and historically, gold has been a benchmark against inflation. But you could do the same thing by owning a house (and you get the benefit of living in it). So you find any NZ based fund with the emphasis on gold. If you're serious about wanting gold, don't invest in it.. you would be better to own it physical. Preferably in 1 oz wafers and not in value added coin form. The gov'ts in both NZ and Canada have no reserves in gold. It's not even a taxable item in NZ in terms of GST or duties. But if you think of gold as an investment.. think again.

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My other new question is more specific to the Smartshares which I bought. On the market there is a split between buy and sell, as is for all shares, giving a possible small loss as margin during the buying and selling process. The other option is to buy the ETF straight from Smartshares which occurs once per month. Therefore, is there a financial advantage in doing the second option? Can the amount be estimated?

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The Bid and Ask price difference is called the spread. Has nothing to do with margin loss. During trading hours, it's just simply a display (in real time) of the seller asking how much they're willing to sell VS the buyer that is what they're willing to pay. If the person puts in a "market order" to BUY then the order gets executed immediately at the ASK price. Same applies to the person wanting to sell. I have no experience with Smartshares so can't comment anything on their trading platform. How are they executing buy orders for customers that pay each day?

All in all, i'm quite biased against the NZ tax treatment against NZ investors in direct stock ownership abroad or in Kiwi Saver ; for the simple reason that paper gains are taxed annually, which has a MAJOR impact against compounding returns. NZ prides on having a simple tax system, but then you do away with any tax planning. There's no CUMULATIVE tax free contribution limits, no tax deferring of investments (so that upon retirement, you structure the sale of your shares, and how much) at a time when your income is already low, so you can be in the low income tax bracket. The reality is there's very little gain for those in Kiwi Saver because when you compare the avg NZ in Kiwi Saver vs the avg Cdn in their RRSP. In 40 years time the Cdn pensioner is going to be miles and miles ahead of the Kiwi person that it would be a laugh.

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Originally Posted by SBQ

ETFs are not a magic bullet. When it comes to investing, nothing is a magic bullet, even owning a house. The reason the VWO is highly invested in Chinese / Asian stocks is due to the type of ETF, hence "Emerging Market". The investor needs to be aware of what area they want their $ put in. Any large % weight allocated to the EFT should be balanced based on 'market size' of the stock. So if you see something like 25% of the ETF is Commonwealth Bank of Australia - that may be perhap that ETF is focused on a certain sector (banks?) and the value of that stock represents an equally weighted proportion of the index it trades in. They're not taking say $1000 and equally dividing it up to buy every stock in the index of same value, it's proportion to the market cap size of each stock and at the end of each day, the ETF has to 'rebalance' the portions so not 1 single stock becomes more riskier than the other.



There won't be. The FIF rules mainly apply to individuals that DIRECTLY hold overseas stocks (exception of some ASX listings). Such as having a discount brokerage account in the US where you directly buy the Vanguard ETF in your name. The reason is the FIF is suppose to regulate individuals away from doing direct investing and channeling them through to invest in local, NZ funds ; after all (and correct me if i'm wrong) it was Bill English that formulated the Kiwi Saver and introduced the FIF tax laws in order to get Kiwi Saver going. The NZ funds themselves in ETF or managed / hedge form operate the investments in 2 ways. Either PIR (Prescribed Investor Rate) or solo where the fund pays a flat rate 28% tax. The PIR is suppose to give the low income investors an advantage be being taxed at the lower bracket. I'm not a fan of this way of investing and personally, the NZ Super pension fund could do a far better job for the NZ citizen by directly buying the ETF as it does not have to deal with paper work and paying ANNUAL TAXATION on the gains. This is why Jacinda Ardern is so fired up about investors owning rental properties because they can long term pay no capital gains tax.



Correct as I mentioned before. Smartshares would end up paying taxes on the paper gains.



At Warren Buffet's said in his 2018 annual meeting, gold will never have the return of a productive asset. https://www.youtube.com/watch?v=tVutQfL3XdU
Generally speaking and historically, gold has been a benchmark against inflation. But you could do the same thing by owning a house (and you get the benefit of living in it). So you find any NZ based fund with the emphasis on gold. If you're serious about wanting gold, don't invest in it.. you would be better to own it physical. Preferably in 1 oz wafers and not in value added coin form. The gov'ts in both NZ and Canada have no reserves in gold. It's not even a taxable item in NZ in terms of GST or duties. But if you think of gold as an investment.. think again.



The Bid and Ask price difference is called the spread. Has nothing to do with margin loss. During trading hours, it's just simply a display (in real time) of the seller asking how much they're willing to sell VS the buyer that is what they're willing to pay. If the person puts in a "market order" to BUY then the order gets executed immediately at the ASK price. Same applies to the person wanting to sell. I have no experience with Smartshares so can't comment anything on their trading platform. How are they executing buy orders for customers that pay each day?

All in all, i'm quite biased against the NZ tax treatment against NZ investors in direct stock ownership abroad or in Kiwi Saver ; for the simple reason that paper gains are taxed annually, which has a MAJOR impact against compounding returns. NZ prides on having a simple tax system, but then you do away with any tax planning. There's no CUMULATIVE tax free contribution limits, no tax deferring of investments (so that upon retirement, you structure the sale of your shares, and how much) at a time when your income is already low, so you can be in the low income tax bracket. The reality is there's very little gain for those in Kiwi Saver because when you compare the avg NZ in Kiwi Saver vs the avg Cdn in their RRSP. In 40 years time the Cdn pensioner is going to be miles and miles ahead of the Kiwi person that it would be a laugh.

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Smartshares units are allocated once a month. So if you invest directly into smartshares ETF's you get whatever the price is at the date that they do their allocation. So you have the movement risk in the interim without holding the underlying ETF. That way you do avoid the spread. The spread is the difference between the buy and sell quote and is set by the market maker. That is the market makers commission if you will. If you are a long term holder of these ETF's then that small spread should not really be of concern.

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Originally Posted by SBQ

The reason is the FIF is suppose to regulate individuals away from doing direct investing and channeling them through to invest in local, NZ funds ; after all (and correct me if i'm wrong) it was Bill English that formulated the Kiwi Saver and introduced the FIF tax laws in order to get Kiwi Saver going.

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OK - I'll correct you.
Labour introduced Kiwisaver in Dec 2007.
FIF rules came in the same year. I wasn't aware that they were linked.