Guide to Exchange Traded Funds

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nyone who has read the financial press regularly over the past couple of years might be forgiven for believing that a wholesale shift in investment patterns by private investors is underway, as they increasingly focus their attention on cheap, liquid, transparent exchange traded funds (ETFs) in preference to conventional collective funds. However, the statistics tell a slightly less clear-cut story. On one hand, global ETF assets under management reached $1 trillion (£656 billion) by the end of 2009, up 45 per cent over the previous year against the MSCI World index rise of 27 per cent. There are now more than 1,900 ETFs available worldwide through 109 providers, listed on 40 exchanges. But the use of ETFs in the UK has been concentrated primarily among institutional investors. A 2009 poll of independent financial advisers by ETF provider iShares and wrap platform Ascentric found that only 19 per cent of UK advisers use ETFs on a regular basis, although 94 per cent of those polled expected their use of the products to increase over the coming 12 months. Much of the resistance to greater incorporation of ETFs in client portfolios is to do with the fact that advisers themselves are wary. The poll found that 85 per cent of IFAs not currently using ETFs felt they don’t know enough about them or find them difficult to access. (Of course, the fact that ETFs don’t pay commission to advisers doesn’t help either.) And if financial advisers feel they are ill-equipped to guide clients this way, it’s unsurprising that many mainstream DIY investors also remain on the sidelines. This guide aims to get rid of some of the mystique surrounding these useful investment tools. We start from first principles, looking at how they work and the various assets to which they give access, their strengths and shortfalls for new investors, and some of the ways that they can be used strategically by private investors as part of a wider portfolio. And when you want to track how ETFs are getting on, each month Money Observer provides regular commentary and performance details for all UK-listed ETFs and exchange traded commodities in its Analyse Money section.

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Introduction

Contents

4 ABSOLUTE BEGINNERS ETFs can often be cheaper than trackers and offer a wider choice of markets, making them well suited to asset allocation

7 TYPES OF ETFs ETFs are available in a wide variety of shapes and sizes. We show you which ones are worth shelling out for

& 9 SHORT leveraged Leveraged and short ETF products are not for the faint-hearted, and there are traps that await the unwary

& 10 nuts Bolts We get under the bonnet of ETFs and explain the fees you are likely to pay, their different structures, and any risks involved

12 portfolio Strategies By using ETFs with actively managed funds, you can add diversification and keep costs down

Editor Andrew Pitts | Written by Faith Glasgow Art editor Chris Aldridge | Production Gary McFarlane Published by Moneywise Publishing, Standon House, 21 Mansell Street, London E1 8AA. Tel: 020 7680 3602 Advertising manager Trevor Leek Web: www.moneyobserver.com E-mail: [email protected]

Faith Glasgow Money Observer ◗ Exchange Traded Funds ◗ May 2010

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STARTING OUT

Money Observer ◗ Exchange Traded Funds ◗ May 2010

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at present, ETFs are markedly cheaper than unit trusts or Oeics.’ However, Darius McDermott, managing director of Chelsea Financial Services, highlights the impact of dealing charges. ‘If you pay £10 or £15 per trade and you're investing large sums, that's really not too big an issue, but in small quantities of £2,000 or £3,000, which is what many new investors are likely to be spending, it bumps up the total cost by maybe 0.5 per cent,’ he warns. Investors comfortable with the indextracking approach, or keen to create a decent long-term ‘core’ for their portfolio onto which they can later bolt other fancier investments (maybe actively managed funds), need to

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“We use ETFs and trackers depending on the market we want to follow” Dennis Hall

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very much a known quantity, which is more than you can say about most managers,’ he observes. If you accept that basic premise, you’re faced with a choice of ETFs or tracker funds, both of which are effectively ‘buying the market’ in question rather than attempting to pick and choose among constituent stocks. Both are low cost, but according to Stuart Fowler, managing director of financial adviser No Monkey Business: ‘For private investors, most ETFs are marginally cheaper than trackers.’ Hall points out that some tracker funds available to the institutional market have been quite aggressive in their pricing – Vanguard, for instance, charges just 0.15 per cent, making its funds an attractive alternative to ETFs. ‘We use both ETFs and trackers, depending on which market we want to follow – we just look at the price of the available funds on the day,’ he explains. ‘For example, for the FTSE 100 we’d probably use the L&G or HSBC index trackers because they are a little cheaper. But in more esoteric markets such as Brazil, which is very popular

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espite the publicity that exchange traded funds (ETFs) have generated, it’s unlikely that many investors new to the stock markets and looking for sensible introductory exposure would turn to them as a starting point. More likely choices would be either an index tracker fund or a ‘populist’ actively managed unit trust or open-ended investment company (Oeic). So the first question that any novice investor should ask themselves is whether or not they subscribe to the widely held belief that most active fund managers will fail to outperform the market over the long term, and therefore that the bulk of their portfolio might as well be in cheap, passively run funds that simply mirror the chosen market index. As Dennis Hall, managing director of Yellowtail Financial Planning, points out, such a strategy solves the very real problem for newcomers of how to choose from the galaxy of active fund managers. ‘An index is

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Exchange traded funds can be slightly cheaper than trackers and offer a wider choice of markets, making them well suited to asset allocation for new investors and those less enamoured of the actively managed path

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think in terms of global diversification and a good spread of markets. John Lang, managing director of independent financial adviser Tower Hill Associates, points out that both equities and fixed-interest markets can be accessed via ETFs. The client’s attitude to risk and age will determine the proportion in each; then the equity portion can be broken down regionally using broad market trackers. ‘We would put say half into a FTSE All-Share ETF; there is a developed countries ex UK product that could be used to get exposure to the US, Europe and Japan with a single fund; and we’d also put maybe 10 per cent into an emerging markets ETF,’ he says. ‘A simple

Private investors need helping hands Why, given the widespread use of index trackers as long-term core holdings by newcomers to the stock markets, do ETFs remain the province largely of relatively sophisticated or active private investors? A key consideration is that only fee-based financial advisers and discretionary wealth managers, looking to keep client costs down, are likely to utilise them on a regular basis at the moment. Commission-based IFAs generally steer clear of them as there’s no trail commission to be earned. That is likely to change with the implementation of the Financial Services Authority's (FSA) Retail Distribution Review in 2012, which will mean advisers wishing to be considered ‘independent’ have to charge clients on a fee basis. It’s probable that ETFs will become more widely used by advisers after that date, particularly as they are highlighted by the FSA as one of the investment tools suitable for retail sales because they are ‘a cheap and transparent way to access the market’.

“The problem is how to create the right portfolio for your needs” John Lang ‘ETFs would work very well for many private investors – the big question is, how do they find out what they need to know about them? Most financial advisers will suggest that something else would be better,’ comments John Lang. ‘The problem for new investors without an ETF-friendly adviser is not the use of ETFs per se, but how to combine them so as to create the right portfolio for their needs,’ he adds. In this respect, he suggests that ETF providers could help both advisers and DIY investors by creating combinations of funds in packages to suit different investor requirements.

global portfolio of bonds and equities could be constructed with just five or six ETFs.’ Hall suggests a portfolio of up to 12 ETFs in order to tap into a mix of major and smaller equity markets as well as gilts and bonds. ‘ETFs are particularly attractive at the moment because right now it’s very difficult to find managers with any conviction over where the markets are going,’ he adds. Once you have decided where you want to invest, which ETF should you choose? There are several major players in the UK ETF market, led by iShares, but also including db x-trackers (from Deutsche Bank) and Luxembourg-based Lyxor. So there may well be a choice of funds doing much the same thing. Both Lyxor and db-x, for example, offer a MSCI Emerging Markets ETF. ‘In such cases, look at the charges, which may vary; then you have to look at the tracking error of the ETF relative to the index [which should be as small as possible, indicating greater accuracy of replication and lower costs],’ advises Lang. One thing to bear in mind when making your choice is that not all ETFs actually replicate the index they follow. Many do,

iShares recognises there is some potential in the idea of pre-combining ETFs to broaden mass market appeal. ‘We already have a "fund of ETFs" proposition in the Netherlands, and we are looking at introducing something similar elsewhere, including the UK,’ says Nizam Hamid, head of sales strategy for iShares. However, he makes the point that these funds are extremely adaptable building blocks that can be used for all sorts of asset allocation strategies. ‘We’re working with advisers to help them understand how ETFs can be used for asset allocation purposes,’ he adds.

but some use a more complicated swapbased system (see page 10). But advisers recommend new investors stick to the more straightforward index replicators. ‘We tend to stick to simpler non-esoteric stuff, partly because of the additional counterparty risk involved with the others but mainly so that we can explain to clients in simple terms exactly what they’ve got,’ says Hall. Ultimately your choice or rejection of ETFs as an introduction to the stock market is likely to be grounded in whether or not you accept the fundamental premise that long-term outperformance through active management is overpriced pie in the sky. As Darius McDermott observes: ‘I have nothing against them – if you want to track an index, ETFs are a good way to do it, though you need to watch dealing charges. But if you’d bought a FTSE 100 ETF at the beginning of 2000 and held it through to the beginning of 2010, you’d have lost 22 per cent. If you’d invested your money with Neil Woodford and his Invesco Perpetual income fund, you’d have gained 102 per cent. Most active managers didn’t do that well of course, but many made some gain.’ Money Observer ◗ Exchange Traded Funds ◗ May 2010

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Types of ETFs

Single-country ETFs

Style ETFs

Commodity ETFs

Short ETFs

Fixed interest ETFs

Currency ETFs

Sector ETFs

Regional ETFs

Pick of the bunch ETFs are available in a wide variety of shapes and sizes tracking commodities and stock markets. We show you which ones are worth shelling out for

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ndices can be created to track all sorts of assets and markets, from the broadbased to the highly specialist, and once you have an index it’s possible to launch an exchange traded fund (ETF) on the back of it. We take a look at a selection of the most common ETF types and the markets they follow.

Geographical ETFs

These take various forms. Many UK investors use ETFs following local single-country indices to get exposure to the stock markets of their home country or other developed markets. According to Nizam Hamid, head of sales strategy at iShares, around three out of iShares’ top 10 sellers tend to be local country funds, although the past year has seen investors moving money out in favour of emerging markets. The iShares FTSE 100, which tracks the performance of the 100 most highly capitalised blue chip companies traded on the London Stock Exchange, is an obvious example, but broader coverage of the UK market could be gained by using a FTSE All-Share ETF from Lyxor and db x-trackers. It’s possible to take a more regional per-

spective within the eurozone through funds tracking the Euro STOXX index. The iShares Euro STOXX 50 provides exposure to 50 of the largest companies across the eurozone. It has gained 57 per cent over the past year to 1 March. But there are alternatives if you’re looking for broader allocations, for example to create a simple but highly diversified portfolio. The Pacific ex Japan, North America, Europe and Latin America are available through iShares, or you could follow the FTSE Developed World ex UK index through iShares or the MSCI Emerging Markets index through iShares, Lyxor and db-x. At the top of the regional pile is the MSCI World index, for which ETFs are available from iShares, Lyxor and db-x. This index offers exposure to around 1,700 companies in more than 20 developed countries worldwide. The iShares fund does not hold positions in the entire index, but takes the ‘optimisation’ approach by including a diverse mix of stocks representing around 85 per cent of the market.

It has gained 65 per cent over the year. However, some of the most popular geographical ETFs over the past year have been single-country emerging market products. ‘Emerging market ETFs have seen greater inflows than all the local and developed world ETFs combined over the last year,’ says Hamid. The choice includes Brazil, Korea, Taiwan, India, Turkey and Vietnam, and there are three broader Bric packages from iShares, Claymore/BNY Mellon and SPDR, but all offer different weightings for country allocations. One that has proved particularly popular is the iShares FTSE/Xinhua China 25 ETF, which gives exposure to 25 of the largest and most liquid Chinese stocks trading on the Hong Kong Stock Exchange. It is up 70 per cent over the past year. ETFs tracking the Brazilian market have done outstandingly well too. The iShares MSCI Brazil fund, which also follows an optimisation approach, tracks the performance of more than 50 diverse large and mid cap com-

“Emerging market ETFs have seen greater inflows than all the local and developed world ETFs combined”

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types of ETFs

THEMES AND SECTORS If you’re keen to follow the rising fortunes of a specific industry sector – say financials – you can do that by buying a sector

ETF. db-x has a range of sector products, including DJ STOXX 600 Banks (which gives exposure to the leading banking companies across western Europe) and DJ STOXX 600 Insurance, both

For the environmentally conscious, iShares offers the Global Clean Energy ETF

panies representing around 85 per cent of the Brazilian market. It has gained 116 per cent over the year.

Style

Some ETFs, labelled as style products, that provide other tools to drill down further into specific market subsets. It’s possible, for example, to invest in indices created on the basis of market capitalisation, dividend payment or value or growth characteristics. ‘The STOXX indices offer a range of European style ETFs, including MidCap, Growth and Value, while the iShares FTSE UK Dividend Plus focuses on the performance of the 50 highest dividend-paying UK stocks,’ explains Nizam Hamid. The latter has returned 55 per cent over the past year.

Fixed interest

iShares dominates the fixed interest ETF market in the UK, with more than 25 products, including short, medium and long government bond funds (most focusing on eurozone bond issues), inflation-linked gilts and corporate bonds. Here, too, investors are able to drill down to refine their investments, for example iShares offers the iBoxx £ Corporate Bond ex Financials ETF, which might be attractive to anyone wary of the outlook for banks in the light of the UK's fragile economic recovery and wanting to exclude them from a basket of investment-grade UK bonds.

Currencies

Currency ETFs have been around for about four years, and have proved very popular during the bear market. They track currency indices that aim to reflect movements in 8


of which have more than doubled in the past year. Other sectoral ETFs include healthcare, food, technology and industrial goods from db-x, while iShares runs regional property products following the FTSE/EPRA indices. iShares also offers several thematic ETFs that track the various indices of the S&P Global Thematic Index series, which is designed to provide investors with exposure to a range of emerging investment themes. iShares’ S&P Global Clean Energy

iShares' Timber Forestry ETF tracks 25 wood and timber firms

ETF tracks the performance of 30 of the largest listed companies involved in clean energy technology, production, or equipment provision. It returned 33 per cent over the year to 1 March. Other S&P global thematic index themes in ETF form through iShares include Emerging Markets Infrastructure, which focuses on

exchange rates between two currencies and exposure to local interest rates. They are swap-based products, backed by collateral for safety, in effect guaranteeing investors the return from exposure to specific currency movements without having to hold or trade any foreign exchange. There’s no need to hold a currency account and there are no futures or forward contracts, so they are a relatively simple way for more sophisticated investors looking for portfolio diversification to play currency markets tactically. But they’re not for novices. The global currency ETF market is dominated by USbased Rydex and Powershares. However, ETF Securities entered the UK market at the end of 2009 with 18 currency ETCs categorised as exchange traded commodities on the London Stock Exchange. These provide long or short passive exposure to G10 currencies, (including the Australian dollar, Swiss franc, euro, sterling and yen), against the dollar. Funds that are long the US dollar and short a G10 currency, especially the euro, have attracted most interest. The Short EUR Long USD fund accounts for 50 per cent of inflows to date in 2010 and the Australian dollar was most popular as a long position.

popular over the past year as investors have looked to traditional safe havens in the face of stock market volatility and dollar weakness. ETF Securities now holds around $9 billion in precious metals, according to co-head of European sales Scott Thompson, including ‘more gold than the UK government’. Other hard commodities are not practical to store (oil and gas for instance), while agricultural products tend to decay over time, so these markets are tracked via the Dow Jones/ UBS futures indices. It’s possible to follow a single commodity such as corn or cotton, but Thompson says many people prefer to diversify with a wide agricultural ‘basket’ or take a macro view with a mixed commodities ETF, as they don’t have the expertise to call individual markets and these broad-based products are less volatile than the individual commodity funds. The main areas of interest, apart from gold, have been in oil and gas (although within quite a limited price range, with traders switching to short positions as the price reaches $80-85 a barrel), and agriculture. ‘Investors generally go for the “frontmonth” futures product that tracks expected short-term price movements, but it is possible to buy longer-dated commodities products that give a bit less volatility and a slightly longer-term perspective,’ Thompson explains. It’s also possible to hedge against price falls by using short commodity ETFs, and increase your exposure via leveraged commodity ETFs. Both are available through ETF Securities.

“It is possible to buy longer-dated commodities that give less volatility and a longer-term perspective” Scott Thompson

Commodities

Only ETFs tracking the spot price of precious metals such as gold, silver, platinum and palladium can hold physical assets. But these funds, especially physical gold, have proved extremely

30 large emerging market companies in the transportation, energy and utilities, and Timber Forestry, which provides access to 25 timber and wood product companies. It’s also possible to track water, shipping, nuclear energy and listed private equity companies, as well as Sharia-compliant companies on a regional or global basis.

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SHORT & LEVERAGED

Complex funds for the savvy Leveraged and short ETF products are not for the faint-hearted and traps await the unwary

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or active traders wanting to manage their position in the markets effectively, leveraged and short exchange traded funds are among the options on offer. Unsurprisingly, interest in their use has risen sharply over the past year as investors have sought to capitalise on the market recovery – and Scott Thompson, co-head of European sales at ETF Securities, anticipates that demand is likely to continue this year in the current uncertain market, as investors look for the return they need from occasional short-term opportunities. So how do they work, and what are their strengths? A leveraged ETF tracks an index like any other, but uses borrowed money as well as your capital, with the aim of increasing returns. ETF Securities runs a ‘2x’ leveraged product, which means that if you put in £1 it’s matched by £1 of borrowed money; then, for every 1 per cent of FTSE gain (or loss) in a day, your investment gains (or loses) 2 per cent. The ETFS leveraged products (unlike other leveraged ETFs) are based on a specially created leveraged index, which includes the interest costs of the borrowed money as a single package to make comparisons easier. It’s important to recognise that in the longer run your leveraged ETF may not match

double the annual return or loss of the index it tracks, because returns are calculated on a daily basis. It could be greater or less than an annual return. This is because the products deliver the daily percentage change, so returns over longer periods are based on the compounding of the daily returns. It is what the industry calls a 'path dependent' product. When the market is rising, more is invested by the ETF each day to keep the 2x leverage constant. However, when it is falling, the opposite happens – the investment is reduced each day. As a consequence, although you are receiving 2x leverage on the upside, you cannot lose more than your entire initial investment. ‘This is one major strength of leveraged ETFs over other leveraged products such as futures or options, where there is no cap on losses and the higher levels of gearing available mean you could lose two or three times your initial investment,’ comments Thompson. Nonetheless, they are clearly inherently more risky than unleveraged positions, because the leverage increases the volatility, and are not designed for long-term buy and hold investors, or indeed for anyone not actively monitoring the market, either up or down. ‘They work very well in strongly directional markets such as the strong rally from March to May last year: traders put stop losses in place

“Leveraged ETFs work well in strong directional markets” Scott Thompson

so that they could get out in a timely fashion,’ Thompson explains. Equally, it’s possible to get 2x short exposure through an ETF when you’re convinced the market is heading south. Short or inverse ETFs are also used by active traders on a relatively short-term basis, either to hedge a position in their portfolio or to speculate on the likelihood that a particular market is going to fall. These are swap-based vehicles (see page 10) that produce a return guaranteed to mirror the performance of the market benchmark – which might be based in equities, property, commodities or fixed income (there’s plenty of choice). However, unlike conventional ETFs, they correlate inversely with that performance – hence the name. So if the benchmark index rises, the ETF falls, and vice versa. As with leveraged ETFs, one big attraction of short ETFs over short investments involving margin commitments is that, although there is no limit to the potential for loss on a short sale because the underlying asset price could in theory rise indefinitely, losses are limited to the original capital invested. In addition, as Thompson emphasises, short ETF s can be used to gain directional access to a range of asset classes, and there are no margin requirements that restrict their use. But both leveraged and short ETFs are designed for sophisticated, active investors who understand the risks involved and are ready to manage their positions. The potential risks for unsuitable users were sufficiently alarming for the Share Centre to withdraw short and leveraged products last year, over concerns that some investors buying them didn’t fully understand their complexity. Money Observer ◗ Exchange Traded Funds ◗ May 2010

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NUTS & BOLTS

Building blocks We get under the bonnet of exchange traded funds and explain the fees you are likely to pay, their different structures, and any risks involved

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ost ETFs are not particularly complex investments; they amount to a kind of hybrid combining the strengths of index tracker funds and traded shares. Like an ordinary index tracker fund, they aim to replicate as closely as possible the index following a particular market or sector. But unlike tracker funds, they are bought and sold on the stock exchange, in the same way as a single company share is. So in other words, you’re buying the performance and diversification of an entire market in a single package. The range of market indices now accessible through ETFs is enormous, and continues to expand. In most cases, the market indices are created by independent index providers such as FTSE International (FTSE), Standard & Poor's (S&P) and Morgan Stanley Capital International (MSCI). For some more esoteric products – for instance certain ‘style-based’ ETFs – providers may make their own indices by filtering down an existing index. As Nizam Hamid, head of sales strategy at iShares, explains, index providers create their own sets of requirements to define an index universe. ‘For fixed income ETFs, they build indices around criteria such as credit quality and maturity,’ he says. For equity ETFs, indices may be constructed on the basis of market capitalisation, theme, sector or geographical region. Thus, it’s possible to buy equity ETFs for single countries such as South Africa or Turkey; regions such as Pacific ex Japan; small or large caps within specific countries or regions; market sectors such as banks or basic resources; and ‘themes/styles’ such as 10 Money Observer ◗ Exchange Traded Funds ◗ May 2010

global infrastructure, value investments and clean energy. Other options include ETFs of commodities such as corn, iron and zinc; currencies, and bonds and gilts. For investors, the attractions of these funds hinge on several key considerations. First, as we’ve seen, they provide instant diversification, and a manageable buildingblock means of putting together a truly global portfolio. They can also be a simple, low-cost way of getting exposure to more esoteric and less accessible markets that are not otherwise available in ‘pure’ form to retail investors. For instance, ETFs tracking the Brazilian stock market have been very popular recently on

“ETFs are transparent – you can trade minute by minute” Graham Spooner

the back of the country’s thriving economy; the nearest unit trust or Oeic equivalent would be a Bric or Latin American fund. Second, they are easily dealt and liquid. They can be traded at any time of day in the same way as a share; if you already have a sharedealing platform in place, this makes the whole process very quick. As Graham Spooner, investment adviser at broker The Share Centre, explains: ‘It’s also transparent, in that you can trade minute by minute at the price you see. With a unit trust trading takes place once a day – if you have to wait until the next day for your trade to go

through, the price may have moved.’ That’s not a serious consideration for buy-and-hold investors, but it does open the door to more active traders who want, for example, to take a short-term position in a particular market suffering a temporary setback and likely to recover in the coming hours or days.

COST control

Third, ETFs have very low running costs compared to funds, because no active manager is involved. According to iShares, the average total expense ratio (TER) of a bond ETF is 0.25 per cent, and for an equity ETF it’s 0.32 per cent. Even the standard index tracker funds available through the retail market have average TERs of 0.8-0.9 per cent, according to Investment Management Association figures, while TERs for actively managed UK equity funds are around 1.5-2 per cent. Nor are there any incidental charges to rack up along the way – stamp duty is not payable on ETFs, unlike shares. However, ETFs do come with some health warnings attached. For a start, you need to take into account the costs of dealing. Through an online broker you should be able to carry out execution-only trades for around £10 to £15. On a £20,000 trade, £15 makes no perceptible difference, but a £15 dealing fee on a £500 trade amounts to an extra cost of 3 per cent.

Another factor that investors should be aware of is that not all ETFs work in the same way. Some, referred to as cash-based funds, do buy all of the securities in the underlying index and hold them as fund assets – a process known as full replication. But for some cash-based ETFs it may not be practical to hold every single constituent of the index. In these cases the ETF provider takes a representative sample of the index constituents and tracks their performance. Thus, the iShares MSCI World ETF holds only 700 securities of the 1,800 in the index itself.

index mimics

when it comes to less easily accessed markets such as commodities. They can also reduce tracking error – the (usually) small but inevitable underperformance of any index tracking fund relative to the index itself – because the full index return is guaranteed by the counterparty to the swap. Against this, swap-based funds are less transparent than cash-based equivalents because they don’t actually hold the physical securities of the index. Moreover, there is the added risk that the counterparty may fail to honour its obligations, although for funds marketed within the EU measures have been taken to limit the counterparty risk involved. ‘It is important to assess all ETF products and their structures (physical or swap) when making an investment decision, as each has its own unique exposure, risk and tax implications,’ warns Nizam Hamid. The bottom line is that with ETFs, as with any other type of investment, you need to take the trouble to understand the rudiments of what you’re actually buying, how they fit in with the other elements of your portfolio, and where the potential hazards lie. Then you’re ready to go.

“Assess all ETF products and structures as each is unique”

Some ETFs do not hold physical assets at all, but instead use total return index swaps to mimic the performance of the index in question. This means that the ETF provider holds other assets as collateral and enters into a swap arrangement with another party, to swap the return on that portfolio with the return on the index to be tracked. In effect, says iShares, investors are ‘buying the performance of the index, not the physical securities it contains'. Swap-based ETFs can be more taxefficient in some cases, and are also useful

Nizam Hamid

Bruce Stout

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PORTFOLIO STRATEGY

Core and satellite of your world By using ETFs alongside some actively managed funds you can invest in the more inaccessible European and emerging markets and gain easy entry to alternative asset classes as well

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ne of the beauties of ETFs is that they offer such a broad spectrum of access – at the one end, full participation (or its equivalent) in a regional or even world index; at the other, the ability to drill down to extremely niche markets that other types of investment fail to reach. As we’ll see, financial planners, especially those with a strong asset allocation bias, make use of that flexibility in a number of strategic ways within client portfolios. There are various nuances, but on the whole, they tend to be employed in one of two key roles. First, they may be employed as a lowcost core holding in some or all of the main markets, particularly in the UK and US where active managers tend to struggle to beat the benchmark consistently. In this role they tend to be in competition with index trackers – which can in many cases work out marginally cheaper. Second, they can be used to plug specific market gaps – commodities, themes, single countries – where index trackers are not available; in some cases they may be chosen as an alternative to actively managed funds.

allocators first and foremost, so we take the view that most returns come from being in the market rather than from being invested with a particular fund,’ he explains. ETFs provide a low-cost route in, and, importantly, they remove the risks involved in trying to predict which manager will outperform the market on a risk-adjusted basis. But Gough is not a slave to the tracker approach. He uses ETFs as a default position, which basically means wherever it’s the most effective way of getting risk-adjusted exposure. Where he doesn’t feel comfortable in selecting an ETF for one reason or another, he uses an actively managed fund.

Passive/active relative risks One approach is that followed by Richard Gough, a financial planner and director at Castle Court Consultants. ‘We’re asset

12 Money Observer ◗ Exchange Traded Funds ◗ May 2010

He explains: ‘It’s easy enough in the UK – we use FTSE 100 and FTSE 250 ETFs, which we reckon give a slightly better return combined than the FTSE All-Share; and if we were currently investing in the US I’d be happy to use the S&P 500. The same goes for Japan and the Far East – there’s a clear-cut choice of ETFs from iShares.’ (Gough sticks with this range because they are cash-based and work best for wrappers such as offshore bonds.) However, he continues, Europe is a different matter because there are so many country/sector/market cap indices and ETFs to choose from. ‘It’s arguably less

ETHICAL ISSUES Anna Sofat makes the interesting point that she has used swap-based ETFs (see page 10) for clients with ethical concerns, who wanted to buy into international markets including the Far East, China and Brazil, but didn’t want to put their money into certain industries within it – tobacco companies

or arms manufacturers, for instance. ‘We had no way of filtering collectives and individual shares presented too high a risk,’ she explains. ‘This way, they benefited from any overall uplift in the market but didn’t actively support the unacceptable elements within it.’

Anna Sofat uses swapbased ETFs for clients with ethical concerns Anna Sofat

risky to appoint an active European equity fund manager, so that is what we do, on the basis of factors such as consistency of performance, ratings and experience.’ For emerging markets, too, Gough uses an actively managed fund, this time alongside an ETF. Commodities are another area for active management, though on different grounds. ‘With a commodity ETF, you can make a call on a specific commodity price, and that’s speculation rather than investment. But blended commodity funds tend to be very bland so we don’t bother with them.’ Any fixed-interest allocation, perhaps surprisingly, is also actively managed, but with strategic bond funds that enable the manager to move across the bond and gilt spectrum as necessary. ‘It’s a very fluid and strategic market,’ comments Gough.

However, Dick makes his choice from both index tracker funds and ETFs, selecting on the basis of both cost and reliability. Currently the bias is towards trackers. ‘At the moment some of the institutional funds, for instance some L&G trackers, are cheaper, so we’re tending to use ETFs only in those markets where a suitable fund isn’t available.’ So, for example, he is able to access emerging markets using a Dimensional tracker. In this case he prefers it to the iShares MSCI emerging markets ETF, partly because the latter contains ‘lots of stuff – in Russia and elsewhere – that you wouldn’t want to touch with a barge pole’. The Dimensional fund, in contrast, uses a screening process to create a more desirable index. As a consequence, at the moment only two ETFs currently feature in his portfolio – both for property coverage, which is not offered through index trackers. ‘We’re using the iShares FTSE/EPRA Developed Market Property Yield and UK Property ETFs,’ says Dick. The choice of which one to include in a portfolio is based on tax considerations. He prefers the idea of global diversification available from the former – but it is a ‘nondistributor’ fund, which means gains are taxed as income at up to 50 per cent,

“With a commodity ETF you can make a call on a price” Richard Gough

Inaccessible investments

Alan Dick, managing director of FortyTwo Wealth Management, takes a similar tack, taking broad market positions and using passive investments for the entire portfolio, ‘except where there’s no way to achieve what we want’.

so he only utilises it within a tax wrapper such as a pension or Isa. In contrast, the UK fund has distributor status, so that gains are taxed as capital gains at only 18 per cent.

Core/satellite

Rebecca Taylor, managing director of Dunham Financial Services, is another financial planner with a passive investment bias. She uses ETFs for the core long-term holdings of most clients, on the grounds that active managers rarely beat the market over that time frame. That includes Europe, despite the plethora of ETF offerings available. ‘It’s a complex area, so we need to be quite specific; we use a broad spectrum of holdings to mimic the main markets,’ she says. Smaller ‘satellite’ holdings tend to be alternative assets that add diversification – and it’s here that she’s prepared to accept more variety in the type of investment vehicle selected, depending on what’s available. ‘We may include active funds – for example, we use the EEA Life Settlements fund and JPMorgan’s Natural Resources fund, and we also use an active fund manager for hedge funds. But there are other alternative investments that happen to be easy to access via ETFs, such as property, gold and private equity,’ she adds.


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PORTFOLIO STRATEGY

DIPPING INTO ESOTERIC MARKETS While asset allocators may use ETFs mimicking the broader indices to gain the kind of core regional exposure they need at low cost, there is also an argument for dipping into the wide and rapidly growing range of more esoteric ETFs available, in order to access specific interesting single country, style, thematic or commodity markets. ‘Drilling down’ in this way tends to be favoured by more active or sophisticated investors who may take relatively short-term or medium-term positions in their chosen assets. For example, says Nizam Hamid at iShares: ‘We have seen a lot of inflow over the past year into specific emerging market countries, including

Mature markets

Even IFAs who generally favour actively managed funds as the basis of client portfolios may justify the use of ETFs for certain core markets – basically those that are so thoroughly researched and accessible that active fund managers find it hard to add much value. As Darius McDermott, managing director of Chelsea Financial Services and a firm believer in the long-term advantages of the best actively managed funds, explains: ‘I would consider using ETFs in areas such as the US large cap market, where it’s very difficult to identify active fund managers that are consistently able to outperform the market.’

Annual rebalancing

Brazil, Korea and China; the physical gold ETF has also been extremely popular.’ Such markets are not generally tracked by index trackers and so would be quite difficult to access otherwise for those who simply want to tap into the growth trend rather than committing themselves to the value judgements of a particular active manager. ETFs lend

“We have seen a lot of inflow over the past year into specific emerging countries” Nizam Hamid

could easily rebalance your allocations.’ Stuart Fowler, managing director of IFA firm No Monkey Business, is one such adviser. ‘For long-term equity holdings that are unlikely to be touched for 20 years plus, we buy institutional tracker funds because they are the cheapest option,’ he explains. ‘But the rebalancing stock is held in ETFs on a broker platform. As individual markets move against each other, our weightings change. There’s no “fixed mix”, but we can make all our adjustments very easily via ETFs.’

Short-term tactical holdings Financial advisers and planners are looking at long-term strategy and therefore tend to leave tactical dodging and weaving to the day traders and active investors who are

Some financial advisers and planners are attracted by ETFs’ advantages of liquidity and simplicity of trading, utilising them as a fluctuating buffer zone around a core holding of long-term funds (active or passive) invested in the same assets. Because ETFs are so easy to trade on the stock exchange, any rebalancing necessary to the portfolio can be done through them, rather than by buying or selling the funds themselves. Nizam Hamid, head of sales strategy for iShares, gives an example. ‘If you had a particular asset class accounting for a chunk of your portfolio, you could work out how much it was likely to move over the longer term, and then hold that margin in ETFs so that you 14 Money Observer ◗ Exchange Traded Funds ◗ May 2010

themselves well, because they provide exposure to the whole market, and are easily bought and sold at close to net asset value. As John Lang, managing director of IFA Tower Hill Associates, observes: ‘They’re a great tool for “detailed granularity”, if you want to home in on the market growth in a specific sector, commodity or country.’

monitoring the market on a close basis. But there may be occasions when a relatively short-term position is justified for clients, as Anna Sofat, managing director of Addidi Wealth, explains. ‘Last year, when the FTSE was down to around 4000 and interest rates had fallen to nothing, there was a big question for some clients over what to do with their money. We put some of them into a FTSE All-Share ETF, because we knew that it had to go up over the coming months, but there was the understanding that we would keep an eye on it and pull out when it became necessary.’ This was intended as a short-term move, adds Sofat, but in the event one client has left her cash invested, drawing profits from time to time as an income stream.

Contacts Providers ETF Securities 020 7448 4330, www.etfsecurities.com iShares 0845 357 7000, www.uk.ishares.com db-x 020 7547 1747, www.dbxtrackers.co.uk Lyxor www.lyxor.com Powershares www.invescopowershares.com

Background information Morningstar www.morningstar.com LSE www.londonstockexchange.com IFAs/brokers Selftrade 0845 070 0720, www.selftrade.co.uk Tower Hill Associates 0208 891 6375, www.towerhillassociates.com

Yellowtail Financial Planning 020 7933 8671, www.yellowtail.co.uk No Monkey Business 020 7736 2434, www.nomonkey business.co.uk Addidi Wealth Management 020 7060 1200, www.addidi.com

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