While many investors have been withdrawing their money from traditional forms of managed fund during the current financial crisis, one area has experienced significant growth. Both the numbers of, and the value of assets under management within, exchange-traded funds (ETFs) have increased dramatically over the past year, and market participants expect this trend to continue in the future.

Deborah Fuhr, global head of ETF research and implementation strategy at Barclays Global Investors, points out that ‘11 April 2009 marked the ninth anniversary of the listing of the first iShares, the first ETFs in Europe that were listed on the Deutsche Börse. Today in Europe there are 672 ETFs with 1,706 listings and assets of US$135.6 billion from 29 providers listed on 21 exchanges.’

And Dan Draper, global head of Lyxor ETFs, confirms that ‘There is an increasing demand for ETFs. Last year there was a US$200 billion outflow from European investment funds and the MSCI World Index fell 43 per cent, but our assets under management grew by 6.5 per cent, and we are continuing to see new assets coming in in 2009.’

A simple approach
Essentially, an ETF is a tracker fund, a ‘passively managed’ basket of investments
that reflects the price movement of those investments. Most often, the basket chosen is an existing index, although ETF providers will also create bespoke baskets that focus on specific sectors or asset classes.

So the ETF displays all the characteristics generally advanced as attractions of passive management – low cost, ease of access, removal of the risk of choosing the wrong individual holding – but it also has other distinct advantages over more traditionally structured funds.

In particular, ETFs are listed on the stock market and are bought and sold like any other share. This means they not only provide a cost-efficient way to get exposure to a particular asset class, but are also highly liquid – investors can get in and out whenever they wish.

It is this combination of flexibility and cost effectiveness that has driven the growth of the ETF market.

John Fletcher, ETF specialist at stockbroker Charles Stanley, suggests that ‘If you are in a position where you want to be in a market just in case it starts to move, ETFs give you a way of getting access to that market very quickly, and also getting out again if you need to. If you have, say, inherited a reasonable sum and don’t want to have it on deposit earning a pittance, but aren’t sure which specific stocks to choose, then ETFs can deal with that problem and still give you market exposure, without tying you to a specific investment.’

A growing market
He adds, ‘The main reason that ETFs are getting so popular is that you now have the sheer breadth of choice. Barclays is still the market leader with its iShares, but there is now a range of other providers with innovative ideas, such as ETF Securities, which has opened up the commodity markets to the average investor.’

ETFs certainly have much lower management charges than actively managed funds. Manooj Mistry, head of db-x trackers UK, points out that ‘For a retail investor, if you tried to buy a specific fund investing in, say, natural resources, you would be typically paying around five per cent upfront in fees plus an annual management charge of around 1.5 per cent. With an ETF, you will have only the broker’s commission as an acquisition cost, but the most this will be is around 0.3 per cent, which is why the ETF is a much cheaper route than an actively managed fund.’

Draper points out that ‘As an investor, you have a number of choices to make. You have to get the asset allocation right and then you have to wrap your investment up in the right tax-efficient vehicle, buy at the right price and so on. Using ETFs means you don’t have to worry about picking the right manager, so that is one less decision you have to make.’

He adds, ‘Of course, you can still use active funds within your wider investment strategy, but with something like fixed income or commodities, for example, where you might not feel you have sufficient expertise, you can use an ETF just to get exposure to that area. That is what institutional investors have been doing for the past five to seven years in Europe, and is exactly the way the market developed in the US.’

Diversifying your portfolio
Eleanor Hope-Bell of iShares emphasises, ‘We don’t say that active management is bad, but, increasingly, monitoring your active managers is taking up a lot of time, and you are not sure if they are going to add value. What we are seeing more and more is that iShares are becoming a core investment in a portfolio because they are cost efficient and give exposure to specific types of investment.’

She adds, ‘It is really a question of risk management. When you are constructing a portfolio of ETFs, you are blending risk and making sure your costs are kept to a minimum.’

Mistry feels that ‘The market is still developing, but we have definitely seen
ETF usage increasing during the crisis. For example, you are now seeing fund managers buying an ETF to get exposure to a particular market, but where they are unsure of which stock to buy.’

He adds, ‘Investors are realising that ETFs are an active management tool. They give investors new ways of accessing new markets and asset classes, and these are often areas that you can’t get at through using traditional funds.’

Nicholas Brooks, head of research and investment strategy at ETF Securities, explains that ‘Investors will want to diversify their portfolios, especially in uncertain times, spreading them across a range of asset classes. The fastest and easiest way to do that is to buy the ETF that gives exposure to the equity index you want or the bond index or commodity index you want, and so on. There is also guaranteed liquidity. Because they are following an underlying index, the market maker will always quote a price.’

Highly liquid
Although the returns from an ETF are not guaranteed – like any passively managed fund, their performance will reflect the performance of the underlying index or basket of assets – Fletcher acknowledges the importance of their transparency: ‘The attractions are the range of products to choose from, their simplicity and the fact that they are very transparent products. After the problems experienced in October last year, when some of the exchange-traded commodities (ETCs) that were backed by AIG got into difficulty, the question of counterparty risk has been largely addressed.’

He adds, ‘The majority of these funds do have the underlying shares behind them. Investors can rest assured that, if something goes wrong, then these shares can be realised. This may have to be at a depressed price, but there is some underlying value.’

Fletcher points out that ‘Another important attraction is that ETFs are traded all the time. You know you are going to get a price for them. With iShares, the spreads are usually pretty tight, although spreads can get much wider with some of the more specialised ETFs, such as the db-xtracker short funds.’

However, Eleanor Hope-Bell stresses the need for investors to be aware of what they are buying: ‘If you look at the early days of the ETF market in the US, it was very simple,
but the numbers of available products have ballooned, which can be hard for the UK investor who is just now entering the market. At iShares, we have tried to educate investors and make them realise that the structure of a particular ETF is very important.’

She insists that ‘You need to ask yourself whether the ETF is transparent, what holdings are underlying it and what the collateral is, if any. Then you also need to look at which benchmark it is tracking and the methodology for constructing that benchmark.’

Dealing with the crisis
Another factor in the broadening of the ETF market has been the global financial crisis. Investors have been equally deterred by the volatility of stock markets and the low returns available from cash, and have sought out alternative asset classes.

ETF Securities’ Nicholas Brooks reports, ‘We have built our business on providing ETCs and we have seen a significant increase in interest since the crisis hit. We are currently sitting with assets under management of US$10.3 billion – last November the figure was $5 billion, so assets have more than doubled since the crisis hit.’

He adds, ‘Institutions have been looking to diversify away from equities and bonds, given the higher risk of inflation with the introduction of quantitative easing. Also, investors want exposure to these assets, but they also want it to be liquid and as cheap as possible, which is where the ETF is so attractive.

‘For example, we have physical gold ETCs, and they are in very great demand at the moment, but there have also been strong flows into long oil ETCs, because investors want to hold hard assets in these uncertain times. They don’t want to hold equities or bonds. Even government bonds have risks because of the high level of government indebtedness.’

However, Dan Draper observes that ‘We are definitely seeing increasing interest in the fixed income market, because a lot of the main actively managed equity income funds have been very heavily weighted towards the financial sector. Consequently, there is growing interest in ETFs for both gilt and corporate bond exposure.’

Manooj Mistry agrees that ‘Fixed income ETFs in general have been beneficiaries as investors have looked to diversify their holdings away from equities. So, for example, we have money market ETFs on sterling, the US dollar and the euro, and the euro product is the most successful ETF in Europe. Investors are moving away from traditional money market funds and using the euro ETF as a way of getting access to overnight money market rates.’

Sophisticated strategies
He adds, ‘Then there are structured ETFs, things like short ETFs, where private investors can take advantage of quite complex strategies. Investors now have an instrument they can use to go short without having to make complex derivative transactions or use contracts for difference (CFDs). They can use it as an investment strategy, and it is a great chance to make money as it provides a great opportunity for dynamic asset allocation.’

Mistry’s group has been among the pioneers of the ‘short ETF’. Charles Stanley’s Fletcher feels that ‘The short ETFs have opened up a fantastic play for people who want to take a view of the market. You used to have to use futures or options to do this, but short ETFs don’t expire at any set time and you don’t have to be a mathematician to understand them. You simply have to decide whether to buy the short db-xtracker or any of the long versions, depending on your view of the market.’

He adds, ‘Providers like iShares, Lyxor, Powershares and ETF Securities have pushed the boundaries on these products, and it will be interesting to see where they go next. I would like to see more currency ETFs coming through as I am asked about them by our clients all the time.’

There are other variations appearing on the ETF theme. Fletcher explains that ‘Powershares are put together to outperform and they have tended to do this on the
upside. It is what is described as “Intelligent Indexation”, where you are not using a capital-weighted index, but trying to put together a basket that will outperform the standard index. But the stock selection side of things is still done for you and you might choose to go with a Powershare ETF because you don’t agree with the mix of the cap-weighted index.’

Emerging from the shadows
However, so far private investors have proved reluctant to join the ETF bandwagon. Nicholas Brooks confirms that ‘In the UK and Europe, it has been mainly institutional investors and private wealth managers, but in the US there is a much broader range of ETF investors. I think that that is because the structure of the investment business here has always been much more commission based and the fees on an ETF are so low that there will be no commission. Therefore, at the moment, you will only find them recommended by IFAs that are fee based, but that will change in the future.’

The reason why ETF providers expect a wider range of financial intermediaries to use their products is the Retail Distribution Review (RDR), conducted by the Financial Services Authority (FSA), which has recommended significant changes in the way that financial advice is provided in the UK.

iShares’ Eleanor Hope-Bell argues that ‘For the UK market, the regulatory changes proposed by the Retail Distribution Review will be significant as it will mean a changing of attitude towards fees and commissions, but a lot of advisers and discretionary portfolio managers are already thinking along these lines.’

She adds, ‘ETFs are a very simple tool to use within the RDR framework, and given what happened at the end of last year, a lot of investors are asking whether their active managers have the performance to justify their fees.’

And Manooj Mistry concludes that ‘If you look at the biggest funds in Europe, it is still the traditional building blocks that are the most popular: the FTSE 100, the Dax and so on. So far, the most retail interest has come from the “hobbyist” investor, people who run their own portfolios and know how to get the best deal. But with the Retail Distribution Review, the market will open up even more in the future and allow advisers to offer
a managed asset allocation portfolio.’