Smart Thinking... the use of ETFs
Investment Week Guide
exchange traded funds
Tracker funds are a more mature investment option
1 August 2005
ETFs are tracker funds that offer access to a whole index through one share, and can prove to be a cost-effective option in comparison to unit and investment trusts
Exchange Traded Funds (ETFs) provide a cheaper and more flexible alternative to many more traditional Isa investments. Having grown in popularity so rapidly during the past few years, ETFs are certainly on their way to becoming a more widely recognised and used investment vehicle. However, they remain under-used by retail investors in the UK, which is somewhat amazing given the clear benefits they offer.
Despite the cumbersome name, ETFs represent a very simple proposition – they are tracker funds that offer access to an entire index through just one share. Essentially, an ETF combines the benefits of a unit trust and an investment trust – both of which are common choices for retail investors.
Like a unit trust, an ETF is an open-ended vehicle: units are created or redeemed as required. Like an investment trust, it is a listed share with an underlying portfolio of stocks.
Unlike unit trusts and investment trusts though, there is no fund manager picking the underlying stocks. Instead, the investor is given exposure to whichever securities make up the equity or fixed income index that the ETF is tracking. For example, the iShares FTSE 100 Fund trades on the London Stock Exchange and tracks the FTSE 100 Index.
An ETF does the same job as an index-tracking unit or investment trust but with some additional benefits. Lower costs are one of these benefits – ETFs are cheap to buy. The annual management fee is as low as 0.2%. Unlike investment trusts, there is no stamp duty to pay either. The only upfront charge is the stockbroker's fee.
Flexibility is another bonus, because an ETF is a share listed on an exchange – you can trade it any time the market is open. Pricing is continuous throughout the day, whereas a unit trust is priced just once a day.
ETFs are not subject to discounts or premiums either, something that affects investment trusts when the share price is lower or higher than the total value of the underlying stocks. This is because large institutions, typically the market makers, can create and redeem ETF shares according to demand.
Therefore, if the value of an ETF share falls below the value of the underlying assets, the professionals will exchange stocks in the index for ETF shares.
These arbitrageurs buy discounted ETF shares and realise the true value by exchanging them for the underlying stocks. This works in reverse when the ETF share trades at a premium. The net effect is that not only does the value of the ETF closely follow the underlying index, but that the share price of the ETF also changes on a real-time basis to reflect the value of the index. Thus, whenever you buy or sell you are going to do so at a price that closely reflects the net asset value of the fund.
Transparency is another advantage. An investor will know exactly which stocks he or she holds at any given time, rather than being reliant on the information the unit or investment trust fund manager produces in the quarterly or annual reports.
As most investors are aware, diversification is key to reducing risk. To the average investor who does not have millions of pounds to invest in buying and selling individual shares, principles such as diversification and asset allocation are difficult to implement unless some form of collective fund is used. Like its collective cousins, the unit and investment trust, an ETF comprises a large number of stocks so the investor's risk is spread over many companies, sectors or countries.
Index tracking funds have established themselves as a mainstream investment product for UK investors. Although active fund managers can at times provide stellar returns, outperforming the index and the funds that track that index by quite some margin, it is very rare that these returns are consistent year after year.
On the other hand, an index fund should outperform the majority of active fund managers over the long term and will at least return as much as the market. Similarly, in times of falling markets many active fund managers will do worse than the index. Conversely, a tracker fund will generally not fall further than the index it tracks.
Many investors' portfolios tend to have a percentage of their underlying assets in low-risk holdings. These elements of a portfolio are often called the building blocks. This could be, for example, tracker funds and or UK equity funds. The remainder of the portfolio is then used to add funds or products with a slightly higher risk profile, such as a US fund and even individual shares.
The percentages invested in the different products will obviously vary for each investor and will depend on his or her risk profile.
A new term to describe this approach is becoming more familiar in the retail investment world – the core satellite portfolio. The core is the low-risk building block element and the satellite portion comprises the slightly more risky funds and products.
Given that they are tracker funds, ETFs are well suited to form the core of an investor's portfolio: they are lower risk than most active funds, they are cheaper than most equity-based funds and they are transparent and flexible. Therefore, an investor could split his or her investment specifically, allocating X% to Europe, US, UK or the eurozone.
Depending on how much risk he or she is willing to take, individual market segments can be added to the portfolio, while specific exposure to large or smaller companies can be achieved easily.
Also, an increasing number of new funds lend themselves to the satellite portfolio approach to gain easy access to markets such as China, European Mid and Small Cap, and European Bonds.
The history of the ETF market in the UK and Europe is relatively brief. Nonetheless, a significant amount of product development and growth has already taken place since 2000. This growth has even outstripped that seen in the US market during its early development and we expect the pace of innovation to remain impressive.
Overall, the UK ETF market has started to mature and a certain amount of further consolidation should be expected among product providers.
However, this does not change any of the fundamental attractions of ETFs and it will probably enhance their appeal going forward.
The ETF market's expansion reflects the fundamental sense these products make to many types of investors, employing a variety of investment strategies. Cost, transparency and accessibility are core characteristics of ETFs and are features that are likely to continue to underpin demand for new products and market growth. While some consolidation should also be anticipated in overcrowded areas, the ETF market is far from mature and is likely to expand to offer products that solve ever more focused investment problems.
Chris Sutton, chief executive officer, iShares Europe
Key points
ETFs are tracker funds which offer access to a whole index through one share, are open-ended vehicles for which units are created or redeemed as required, but do not have a fund manager picking the underlying stocks.
Index-tracking funds should outperform the majority of active fund managers over the long term and will at least return as much as the market, while during falling markets a tracker fund will generally not fall further than the index it tracks.
There should be some consolidation in the ETF market in overcrowded areas, but this market is far from mature and is likely to expand.
Source: Investment Week
© Incisive Media Investments Ltd 2004