Exchange-traded funds (ETFs) are pooled investments that aim to track particular indices, such as the FTSE 100, the Dow Jones Industrial Average or the Investment Property Database Index. Colin Tipping, client director at Barclays Global Investors, one of the major UK providers of ETFs to UK investors under the brand iShares, explains, ‘Although they are collective investment schemes, they differ from more traditional funds in that they combine the best features of direct securities and collective investment schemes.’

According to Tipping, ETFs are as flexible as equities because they are traded throughout the day on a variety of stock exchanges. But, like a fund, they also seek to reflect the performance of a particular index by investing in ‘a diversified underlying basket of assets’.

Another provider of ETFs is Lyxor. Daniel Draper, head of Lyxor ETFs, UK and Ireland, underlines the simplicity of the product: ‘ETFs are really open-ended funds but wrapped and traded like shares. People who are used to share trading will be fine investing in them.’

Market coverage

ETFs currently cover a range of markets – effectively they can be based on anything with an index – and the breadth and depth of the market is growing as more providers enter and more products are launched. ‘ETFs track almost every index in existence, covering US stocks and bonds, and international stocks,’ explains Salim Sebbata, director, UK retail at E*Trade. ‘Within these groups you find specific sectors, such as media, healthcare, energy and capitalisations (large or small cap) and specific regions, including emerging markets.’

There are currently 916 ETFs worldwide with 1,359 listings on 39 exchanges all over the globe and assets of US$666.2 billion (£336.5 billion) under management, according to the most recent figures produced by Morgan Stanley. Furthermore, it has predicted that this figure will exceed $2 trillion by 2011 if the current growth is maintained.

At the moment, the US and Europe lead the way in terms of ETF development. The US market is currently the largest, with 480 products and $471.29 billion in assets under management. The European ETF sector is slightly less developed, with 312 listed ETFs and $105.53 billion of assets under management. The next closest region is Japan, which has 13 ETFs and assets under management of $38.86 billion. Other participating markets include Hong Kong, Australia, India, Brazil and South Africa.

The UK, although a long way behind the likes of America, has a buoyant and fast-growing ETF market, not least due to changes contained in the 2007 Budget that abolished the payment of stamp duty on these products. According to James Oates, marketing manager at new provider SPA ETF Europe, this signals big things for domestic ETF markets. He observes that ‘In the UK, the abolition of tax on the underlying stocks has resulted in an opportunity for the London market to become more of a leader. All the fundamentals are there for that to happen.’

Indeed, although there are only a handful of providers, many more of those involved in the sector believe this won’t be the case for long. Sebbata says, ‘At E*Trade, the popularity of ETFs among retail investors is apparent. We went from offering 57 ETFs to 338 in less than two years.’

So what can ETFs add to your portfolio? Is this prediction of the rise of the ETF wishful thinking on the part of those involved in creating and selling ETFs, or is there more to it?

Diversification

ETFs provide an easy route to portfolio diversification. You can invest in an ETF quickly and cost effectively and gain exposure to a spread of holdings rather than just one share. Sheridan Admans, investment adviser at online stockbroker The Share Centre, explains, ‘Investors use ETFs as a diversification tool within their portfolios. It costs far less than the cost of the underlying stocks.’

In addition, according to Admans, ETFs don’t require the amount of research involved in identifying and investing in a specific stock. ‘Investors can buy the core UK stocks, for example – the ones that they know like Vodafone – and then pick up exposure to overseas stocks too through an ETF,’ he adds.

Lyxor’s Draper says, ‘The philosophy behind ETFs and other passive investments is largely to be investing as cheaply as possible, especially over the long term.’

He explains that you could use ETFs to target various sectors or regions relatively cheaply: ‘After fulfilling your asset allocation strategy, you can use your remaining cash for more risky and expensive investments. This is, if you like, the “core/satellite” approach. The ETFs make up the core and the satellite contains the riskier investments.’

Accessing ETFs

ETFs can be purchased quickly and easily through a stockbroker or via an online brokerage. They also benefit from continuous trading, as John Fletcher, a stockbroker at Charles Stanley, explains, ‘This means you can always get an up-to-date price, unlike with a unit trust, for example, which is quoted on a weekly or daily basis.

‘ETFs are also very liquid,’ he continues, ‘but not in the normal sense. Usually, a liquid stock means that there is already a lot of it out there and that a lot of people are trading it. But with an ETF, if demand exceeds supply, the provider can just create new shares.’

The ease of purchase is also matched by the costs involved, which, relatively speaking, tend to be low. ETFs tracking standard indices, such as the FTSE 100, will carry low costs; however, these will obviously increase for those ETFs investing in complicated or overseas areas, such as private equity or emerging markets.

E*Trade’s Sebbata says, ‘ETFs have expense ratios that reflect what providers charge for running the ETF. However, because ETFs are not actively managed like traditional funds, the expense ratio is very low, averaging around 0.5 per cent.’

Several other costs are involved that, again, mirror ETFs’ similarity to standard equity-based investments. ‘There is a stockbroker commission – anything from a fixed cost online through to a percentage charge for the more traditional stockbroker model,’ explains Tipping. ‘Just as with any equity, there will also be a spread determined by market conditions and this will range from a few basis points for mainstream markets through to higher amounts for alternatives.’

ETFs v trackers

With the wide availability of tracker funds, you wouldn’t be blamed for wondering what it is about ETFs that makes them stand out. Why would you transfer your investments from a tracker fund to an ETF considering that, for all intents and purposes, they both do the same thing: track an index?

According to SPA ETF Europe’s James Oates, new entrants to the ETF market are set to give the more established mutual fund sector a run for its money. He says, ‘We are selling to investors who are currently in an averagely managed mutual fund and are disappointed by the recent performance. ETFs can be used as a method of developing greater performance at a lower cost.’

Nik Bienkowski, head of research at another ETF provider, ETF Securities, is also highly optimistic about the rise of this type of investment in the UK. ‘ETFs are essentially the new mutual funds – those based on passive benchmarks, anyway – but they’ve been made better,’ he enthuses. ‘Why pay someone two per cent to track the FTSE 100 index for you? ETFs are low cost, trade throughout the day and you can hold them in a brokerage account. In addition, you have perfect tracking of an index, which is not always the case with a fund manager.’

The Share Centre’s Admans also highlights the possibility of performance anomalies between tracker funds and ETFs. ‘This is because ETFs track the whole market while a fund uses sampling techniques so might track 70 of the FTSE 100 rather than the full 100,’ he explains. ‘This means there is a slight difference in returns, but it could be more or it could be less – the 70 could do better than the 100 or vice versa.’

In his opinion, the choice is clear-cut: ‘You can buy and sell an ETF immediately, but with a fund you have to go through a more rigorous process and they are only priced once a day. You can’t sell at 2pm, for example, so you usually have to wait until the next day for the process to be completed. Funds also use “forward pricing” so you don’t know what the exact price will be ahead of the trade.’

Riding out the peaks and troughs

ETFs are also useful holdings during periods of market volatility, according to Lyxor’s Draper, allowing investors to stick to their asset allocation strategy during difficult times. ‘It is more difficult for active managers to make the right choices during such periods so an ETF will give cheap exposure to the FTSE. You aren’t taking a big risk but you’re still sticking to your asset allocation strategy.’

In addition, as already mentioned, the share-like quality of ETFs means investors can reduce their exposure to any volatility quickly. Admans explains, ‘We recently saw a 300-point drop in the market. With an ETF, an investor could have sold out quite early in the day and minimised their losses. However, with a fund, the investor wouldn’t have been able to sell until the next day, even if they had started the process that afternoon.’

As Draper pointed out earlier, however, ETFs and mutual funds can be combined to build a diversified portfolio, covering all your asset allocation needs. Indeed, Admans argues, ‘Funds will still have a place in private investor portfolios – especially as a long-term product rather than a trading tool, which is what an ETF is. With a fund, the manager is working very hard to research a specific market very deeply. An ETF simply tracks an index.’

Further information:
Exchange-traded commodities (ETCs)
Commodities, traditionally seen as the preserve of wealthy or institutional investors, are now more widely available to retail investors. This can be attributed to a number of factors, not least the development of exchange-traded funds (ETFs) dealing in commodities, also known as exchange-traded commodities (ETCs).

Commodities trading involves either access to large and varied storage facilities (able to hold anything from grain, oil, butter or even hogs) or an understanding of futures trading, so retail investors have largely kept away. However, ETCs act in the same way as ETFs in that they offer broad-based access to commodities trading without the need for storage or an in-depth knowledge of how futures contracts are traded.

ETF Securities offers more than 40 ETCs, tracking sectors such as energy and agriculture. Nik Bienkowski, head of research at ETF Securities, outlines the provider’s latest product development: ‘In April 2007, we launched five new precious metals ETFs backed by physical metals. This type of commodity is easier to store than, say, pigs or oil, but if a commodity ETF is not backed by the physical product, it is priced on the futures market.’

The futures market

Futures trading involves investing in the right, but not the obligation, to either buy (a call option) or sell (a put option) a certain amount of something at a certain price on a fixed date in the future.

The beauty of the futures market is that you never actually have to take delivery of the assets in which you are investing. Before the contract matures (and you end up with an oil tank sitting on your doorstep), you sell the option and the money is reinvested into another contract, kicking off the whole process again.

There are obviously pros and cons to investing in commodities futures. For more information, see What Investment’s forthcoming guide to commodities at www.whatinvestment.co.uk
This article is from the September 2007 issue of What Investment.