Exchange-traded funds (ETFs) offer investors the opportunity to spread their risk across entire sectors or specific baskets of shares. After a relatively slow start in this country – the first UK-listed ETFs appeared about eight years ago – these investment vehicles are now surging in popularity.

Launched in the US in 1993, they reached the UK in 2000, but for years have been missing from the retail investor’s radar, despite being ideally suited to investors who already hold a dealing account or are used to buying and selling equities.

ETFs are designed to track a particular exchange or index and allow investors to buy into a range of companies through a single share. As Manooj Mistry, head of db x-trackers UK, the ETF arm of Deutsche Bank, points out, ‘Investors can really tailor their investment decisions according to market conditions and what their views are. Rather than becoming a stockpicker, they can basically choose the asset class, region or country that they believe is going to do well. This is an opportunity for people to change the way they invest by taking advantage of hot trends and being much more dynamic.’

Lower costs
The main reason ETFs are gaining popularity is because of their low costs, compared to traditional tracker funds. Most funds charge one per cent to two per cent as an annual management fee, but the average charge for an ETF is a mere 0.5 per cent.

Mistry explains, ‘You are paying a broker fee upfront, but it is significantly less than a traditional tracker fund and the management fees are also much more competitive. For example, if you wanted to invest in an emerging market actively managed fund you would be faced with a fee of between 1.5 and two per cent, whereas with our MSCI emerging market ETF you would only be paying 0.65 per cent.’

ETFs are primarily linked to established market or sector indices. Barclays Global Investors is a leader in the field and on the UK market it offers a broad spread of ETFs called iShares. They cover the FTSE 100, 250, Euro 100, Eurotop 100, S&P 500, Euro Stoxx 50, DJ Stoxx 50 as well as dollar, euro and sterling corporate bonds. Newer iShares include iShares MSCI Korea, iShares FTSE/EPRA European Property Index Fund and iShares e Inflation Linked Bond.

On the US markets there is an overabundance of ETFs made available through a number of established US providers, including State Street, Lipper, Vanguard and Merrill Lynch.

Their low costs, accessibility and simplicity have made them favourable to the more savvy investor, but it wasn’t until recently that the range of providers and products available really took off.

In 2006, the then-Chancellor, Gordon Brown, allowed non-UK-domiciled ETFs to list in the UK on the same terms as those domiciled in Ireland. This meant UK investors could buy non-UK ETFs without having to pay stamp duty. Often referred to as the ‘big bang’ for ETFs, this change paved the way for established foreign providers to enter the UK, such as Lyxor, a subsidiary of Société Général, and Deutsche Bank.

Up, up and away
It used to be necessary to buy ETFs listed overseas to get exposure to more sophisticated strategies but you can now stay onshore. Although the UK ETF range has yet to catch up with the variety available in the US and Europe, it is growing rapidly.
In 2007, there were 100 ETF launches across Europe and there are now more than 120 listed on the London Stock Exchange alone. The US currently has 533 ETFs with US$530.5 billion (£265.56 billion) invested in the products. Europe has 386 ETFs with US$125.9 billion of assets under management.

James Oates, head of marketing at SPA ETF, says, ‘Europe has clearly emerged as the biggest growth area for ETFs, with more investors coming in and more funds now available than ever before.’

If you want stock market exposure, ETFs allow you to access large-caps, mid-caps and small-caps. ETFs can easily be shorted using contracts for difference (CFDs), which opens up a wide range of possible strategies to the experienced trader or investor. Db x-trackers is the first provider to bring short ETFs to the marketplace, enabling investors to better manage their portfolios and use ETFs either as a vehicle for long-term asset allocation or as a tactical tool for making money.

Db x-trackers brought its Frankfurt-listed ShortDax, DJ EuroSTOXX 50 Short and S&P 500 Short exchange-traded funds (ETFs) to the London market in February 2008, allowing traders to simply buy shares in these short ETFs and make positive returns in inverse proportion to falls in the Dax, DJ Eurostoxx 50 and S&P 500.

‘A year ago, we started working with Deutsche Börse and Dow Jones to create the ShortDax and Short Eurostoxx 50 indices,’ explains Mistry. ‘These are real-time indices giving inverse, or “delta minus one”, performance on an intra-day basis. We then launched the ETFs in Frankfurt shortly before the credit crisis began, which was an opportune time to launch short products.’

Traditionally, funds are long only, but as Sheridan Admans, investment adviser at The Share Centre, points out, ‘Typically investors buy an asset and hold it until the time comes to sell it – unless you’re in a hedge fund – but some investors would prefer to go short. Take Brazil, for example. If you think it may take a turn for the worst and its market isn’t likely to do very well over a certain period, you can buy an investment that will make money from it falling. This different, complex view to the market gives investors exposure to something that they would have had to have accessed through spread-betting or by investing in the options or futures markets.’

Accessing a super-cycle
Investors can now gain direct exposure to commodity futures prices through the newer exchange-traded commodities (ETCs). These are traded just like shares and provide exposure to an ever-increasing range of commodities and commodity indices.

Admans explains, ‘ETCs are fairly new to the UK market and are proving more and more popular as we go through this commodity super-cycle. Investors are finding it an asset class that they have never really had access to previously, apart from if they were to invest in a company, which then could perform well – or not.’

ETCs are a flexible way for investors to get in and out of the market very efficiently and quickly if they trade on a continuous basis throughout the day. They are priced in two different ways. With gold and silver the price is based on the value of physical bars. Spot pricing (or cash pricing) – the present delivery price of a given commodity being traded on the spot market – is used for other commodities, such as agriculture.

The upsurge in interest in the commodity markets from investors has helped the ETF market considerably and because these are assets that are traditionally hard to invest in, but which have now become very accessible, availability has ballooned as a result.
‘We are seeing an explosion in wheat and biofuels at the moment, which will continue to improve as the infrastructure in these economies grows,’ says Admans. ‘Cotton and sugar are starting to take off, along with various others that are influenced by the growth of the Asian economies and Eastern Europe.’

Tracking the debate
Investors and advisers alike have been debating which product is better for some time and, as Admans illustrates, this ultimately comes down to tracking error. ‘If you take an index like the All Share, you might find that the traditional unit trust tracker fund has an error margin of 0.5 per cent, which means that it is not tracking it perfectly to cover costs, reinvestment of income and the total number of holdings. The different characteristics ETFs have to normal tracking mean they are much more efficient, but it will obviously be a couple of years before we see clear results as to which actually performs better.’

He adds, ‘It also comes down to the investor and how long they want to be invested in
these instruments. An ETF is very liquid and the investor can be in and out within that day. With a fund, you are looking at an investment of three to five years and some of these instruments can’t be used in combination with other products such as stakeholder pensions.’

An obvious advantage that ETFs hold over alternative investments is that they can be held within an individual savings account (ISA) or self-invested personal pension (SIPP). James Oates, head of marketing at SPA ETF, points out, ‘Many retail investors are only just becoming aware of ETFs, but we have still witnessed a growing interest from many retail investors looking for an alternative to actively managed investment products. This year we expect to see a substantial growth of assets under management across the sector.’

He adds, ‘In the long term, ETFs will prove extremely popular with SIPP and ISA investors, as they have done with retail investors in the US. The combination of instant diversification, low cost and the flexibility offered by ETFs will lead to the exchange-traded market evolving and more specialised products on the market.’