Exchange Traded Funds – the best of both worlds?

Exchange Traded Funds or (ETFs) are a fast growing part of the investment landscape. In 1997 there were some $25bn invested in ETFs globally; by 2013 this had grown to $2.2 trillion. This compares to $9.4 trillion in all open ended funds, so they are significant. We think investors should consider ETFs as an alternative to other funds, particularly for mainstream and international exposure; this article is an introduction to ETFS and, although we have used ETFs in our specialist portfolios in the past, we intend to complement our existing portfolios on the web site with strategies more specifically based around ETFs.

As can be seen from the figures below, mainstream fund managers are heavily involved in the market; and while the US still dominates, European based ETFs are growing rapidly.

Top Five Providers (with owner)

1. iShares (Blackrock)
2. SPDR ETFs (State Street Global Advisors)
3. Vanguard
4. PowerShares (Invesco)
5. DB x-trackers (Deutsche Bank)

Top Five Funds

1. SPDR S&P500 ($147,923m)
2. Vanguard Emerging Markets ($51,466m)
3. iShares MSCI EAFE ($45,904m)
4. iShares Core S&P500 ($45,756m)
5. iShares MSCI Emerging Mkts ($42,272m)

ETFs are an amalgam of open ended funds (mutual funds as in the US or unit trust/OEICs in the UK) and closed end funds, eg. investment trusts. They are like open ended funds in that you can buy and sell them at the value of the underlying investments (ie. net asset value or NAV), or very close thereto, rather than at a share price determined by supply and demand as is the case with investment trusts. On the other hand, unlike open ended funds, they are quoted on the stock exchange and can be bought and sold during the trading day at a transparent price.

The mechanism for making this work is that an investment bank market maker commits to buying and selling the parcel of shares (ETFS are usually, but not exclusively, based on indices) and will quote a price reflecting the underlying value of the shares at any one time. Because the holdings are known exactly, if the price were to diverge too much from their underlying value, then it would be possible to make a free arbitrage profit by buying the ETF and selling the underlying or vice versa.

For comparison, the main characteristics of the three main investment vehicles available to UK investors are set out below:

Three Investment Vehicles

	OEICs	ETFs	Investment Trusts
Open ended	✓	✓	x
Closed ended	x	x	✓
Price quoted during day	x	✓	✓
Trade at NAV	✓	✓/?	x
Charges	Depends	Lowest	Lower?
Gearing	x	?	Can
Underlying	Physical	Physical or Synthetic	Physical
Best suited	Liquid	Tactical	Illiquid
Style	Mainly active	Passive	Active
Dividends	Distributing or Accumulating	Distributing or Accumulating	Managed Distribution

 

Typically, the main advantages of ETFs are seen as:

• Lower charges because the investments are usually based on an index and not subject to active management.
• The ability quickly and economically to gain an exposure to a particular investment theme or geographic area (tactical asset allocation).
• Transparency of pricing and holdingsWhere they are quoted on exchanges outside of the UK they don’t attract stamp duty.

The main disadvantages are:

• There is no active management so the performance will always be slightly less than the chosen index, because of charges.
• Where the whole index is not physically replicated (ie the ETF does not hold all the underlying holdings but only a representative sample) the performance may diverge from the index.
• Particularly where the index is replicated by derivatives (so called synthetic replication) then there may be increased settlement risk, with exposure to investment banks.

Conclusion

We think ETFs can be a useful addition to an investor’s armoury, although we would avoid synthetic ETFs using derivatives. They may be most appropriate to use where there is strong conviction about an investment area, but it is not practical or economic to select individual stocks. In our portfolios we have used IUSD (iShares S&P 500 ETF) and IJPH (iShares MSCI Japan GBP Hedged), for example. We also recommend using IGLT (iShares Core UK Gilts) for investors who don’t want to hold individual gilts.

We will be returning to this subject.