guide to exchange traded funds
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FREE with thE MAY 2010 Edition oF MonEY obsERvER
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Emerging
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Them
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Fixed
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Short
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Leveraged
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Money Observer Exchange Traded Funds May 2010 3
Contents
Introduction
Edtor Anew Ptt | Wrtte by Fath GagowArt edtor Ch Age | Prodcto Gay McFaane
Published byMoneywise Publishing, Standon House,
21 Mansell Street, London E1 8AA. Tel: 020 7680 3602
Advertising managerTrevor Leek
Web:www.moneyobserver.com
E-mail:[email protected]
Anyone who has read the nancial press
regularly over the past couple o years
might be orgiven or believing that a
wholesale shit in investment patterns
by private investors is underway, as they
increasingly ocus their attention on
cheap, liquid, transparent exchange traded unds (ETFs) in
preerence to conventional collective unds.
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 o 2009, up 45 per cent
over the previous year against the MSCI World index rise o
27 per cent. There are now more than 1,900 ETFs available
worldwide through 109 providers, listed on 40 exchanges.
But the use o ETFs in the UK has been concentrated
primarily among institutional investors. A 2009 poll o
independent nancial advisers by ETF provider iShares and
wrap platorm Ascentric ound that only 19 per cent o UK
advisers use ETFs on a regular basis, although 94 per cent o
those polled expected their use o the products to increase
over the coming 12 months.
Much o the resistance to greater incorporation o
ETFs in client portolios is to do with the act that advisers
themselves are wary. The poll ound that 85 per cent o IFAs
not currently using ETFs elt they dont know enough about
them or nd them dicult to access. (O course, the act
that ETFs dont pay commission to advisers doesnt help
either.) And i nancial advisers eel they are ill-equipped
to guide clients this way, its unsurprising that manymainstream DIY investors also remain on the sidelines.
This guide aims to get rid o some o the mystique
surrounding these useul investment tools. We start rom
rst principles, looking at how they work and the various
assets to which they give access, their strengths and
shortalls or new investors, and some o the ways that
they can be used strategically by private investors as part
o a wider portolio.
And when you want to track how ETFs are getting on,
each monthMoney Observer provides regular commentaryand perormance details or all UK-listed ETFs and
exchange traded commodities in its Analyse Money section.
Faith Glasgow
7TYPESOF ETFsETFs are available in a
wide variety o shapes
and sizes. We show you
which ones are worth
shelling out or
10nuTS &BOlTsWe get under the bonnet
o ETFs and explain the
ees you are likely to pay,
their diferent structures,
and any risks involved
9SHORT &lEvErAGEdLeveraged and short ETF
products are not or the
aint-hearted, and there
are traps that await the
unwary
12PORTfOliOsTrATEGiEsBy using ETFs with
actively managed
unds, you can add
diversication and keep
costs down
4ABSOluTEBEGiNNErsETFs can oten be cheaper
than trackers and ofer a
wider choice o markets,
making them well suited
to asset allocation
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4 Money Observer Exchange Traded Funds May 2010
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Passiveinvestingsgreat leapforward
Despite the publicity that
exchange traded unds
(ETFs) have generated,
its unlikely that many
investors new to the stock
markets and looking or
sensible introductory
exposure would turn to them as a starting
point. More likely choices
would be either an index
tracker und or a populistactively managed unit trust
or open-ended investment
company (Oeic).
So the frst question that
any novice investor should ask
themselves is whether or not
they subscribe to the widely
held belie that most active
und managers will ail to outperorm the
market over the long term, and thereore that
the bulk o their portolio might as well be in
cheap, passively run unds that simply mirror
the chosen market index.
As Dennis Hall, managing director o
Yellowtail Financial Planning, points out,
such a strategy solves the very real problem
or newcomers o how to choose rom the
galaxy o active und managers. An index is
very much a known quantity, which is more
than you can say about most managers, he
observes.
I you accept that basic premise, youre
aced with a choice o ETFs or tracker unds,
both o which are efectively 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 o nancialadviser No Monkey Business:
For private investors, most
ETFs are marginally cheaper
than trackers.
Hall points out that some
tracker unds available to the
institutional market have
been quite aggressive in their
pricing Vanguard, or instance, charges just
0.15 per cent, making its unds an attractive
alternative to ETFs. We use both ETFs and
trackers, depending on which market we
want to ollow we just look at the price o
the available unds on the day, he explains.
For example, or the FTSE 100 wed 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
at present, ETFs are markedly cheaper than
unit trusts or Oeics.
However, Darius McDermott, managing
director o Chelsea Financial Services,
highlights the impact o dealing charges.
I 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 o 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 comortable with the index-
tracking approach, or keen to create a decent
long-term core or their portolio onto which
they can later bolt other ancier investments
(maybe actively managed unds), need to
Exchange traded unds can be slightly cheaper thantrackers and ofer a wider choice o markets, makingthem well suited to asset allocation or new investors
and those less enamoured o the actively managed path
We use ETFsand trackersdepending onthe market wewant to followDennis Hall
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Mo Ob Exchange Traded Funds May 2010 5
think in terms o global diversifcation and a
good spread o markets.
John Lang, managing director o
independent nancial adviser Tower Hill
Associates, points out that both equities
and xed-interest markets can be accessed
via ETFs. The clients 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 hal 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 und;
and wed also put maybe 10 per cent into an
emerging markets ETF, he says. A simple
global portolio o bonds and equities could
be constructed with just ve or six ETFs.
Hall suggests a portolio o up to 12 ETFs
in order to tap into a mix o major and
smaller equity markets as well as gilts and
bonds. ETFs are particularly attractive at the
moment because right now its very dicult
to nd 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(rom Deutsche Bank) and
Luxembourg-based Lyxor. So there may well
be a choice o unds doing much the same
thing. Both Lyxor and db-x, or example, ofer
a MSCI Emerging Markets ETF.
In such cases, look at the charges, which
may vary; then you have to look at the
tracking error o the ETF relative to the
index [which should be as small as possible,
indicating greater accuracy o 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 ollow. Many do,
but some use a more complicated swap-
based system (see page 10). But advisers
recommend new investors stick to the more
straightorward index replicators. We tend
to stick to simpler non-esoteric stuf, partly
because o the additional counterparty risk
involved with the others but mainly so that we
can explain to clients in simple terms exactly
what theyve got, says Hall.Ultimately your choice or rejection o
ETFs as an introduction to the stock market
is likely to be grounded in whether or not
you accept the undamental premise that
long-term outperormance through active
management is overpriced pie in the sky.
As Darius McDermott observes: I have
nothing against them i you want to track
an index, ETFs are a good way to do it,
though you need to watch dealing charges.
But i youd bought a FTSE 100 ETF at the
beginning o 2000 and held it through to
the beginning o 2010, youd have lost 22 per
cent. I youd invested your money with Neil
Woodord and his Invesco Perpetual income
und, youd have gained 102 per cent. Most
active managers didnt do that well o course,
but many made some gain.
Why, given the Wide-
spread use o index track-
ers as long-term core holdings
by newcomers to the stock
markets, do ETFs remain the
province largely o relatively
sophisticated or active private
investors? A key consideration
is that only ee-based nancial
advisers and discretionary
wealth managers, looking to
keep client costs down, are
likely to utilise them on a regu-
lar basis at the moment. Com-
mission-based IFAs generally
steer clear o them as theres no
trail commission to be earned.That is likely to change
with the implementation o
the Financial Services Author-
ity's (FSA) Retail Distribution
Review in 2012, which will mean
advisers wishing to be con-
sidered independent have to
charge clients on a ee basis. Its
probable that ETFs will become
more widely used by advisers
ater that date, particularly as
they are highlighted by the FSA
as one o the investment tools
suitable or retail sales because
they are a cheap and transpar-
ent way to access the market.
ETFs would work very well
or many private investors
the big question is, how do
they nd out what they needto know about them? Most
nancial advisers will suggest
that something else would be
better, comments John Lang.
The problem or new investors
without an ETF-riendly adviser
is not the use o ETFs per se,
but how to combine them so as
to create the right portolio or
their needs, he adds.
In this respect, he suggests
that ETF providers could help
both advisers and DIY investors
by creating combinations o
unds in packages to suit difer-
ent investor requirements.
iShares recognises there is
some potential in the idea o
pre-combining ETFs to broaden
mass market appeal. Wealready have a "und o ETFs"
proposition in the Netherlands,
and we are looking at introduc-
ing something similar else-
where, including the UK, says
Nizam Hamid, head o sales
strategy or iShares.
However, he makes the
point that these unds are
extremely adaptable building
blocks that can be used or all
sorts o asset allocation strate-
gies. Were working with advis-
ers to help them understand
how ETFs can be used or asset
allocation purposes, he adds.
private investOrs nEEd hElping hands
The problem
is how tocreate the rightportfolio foryour needsJohn Lang
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Money Observer Exchange Traded Funds May 2010 7
ETFs are available in a wide variety of shapes and sizes tracking commodities andstock markets. We show you which ones are worth shelling out for
Pick of the bunch
Indices can be created to track all sorts
o assets and markets, rom the broad-
based to the highly specialist, and
once you have an index its possible to
launch an exchange traded und (ETF)
on the back o it. We take a look at a
selection o the most common ETF
types and the markets they ollow.
GeoGraphical ETFsThese take various orms. Many UK inves-tors use ETFs ollowing local single-country
indices to get exposure to the stock markets
o their home country or other developed
markets. According to Nizam Hamid, head o
sales strategy at iShares, around three out o
iShares top 10 sellers tend to be local country
unds, although the past year has seen inves-
tors moving money out in avour o emerging
markets.
The iShares FTSE 100, which tracks the
perormance o the 100 most highly capital-
ised blue chip companies traded on the Lon-
don Stock Exchange, is an obvious example,
but broader coverage o the UK market could
be gained by using a FTSE All-Share ETF rom
Lyxor and db x-trackers.
Its possible to take a more regional per-
spective within the eurozone through unds
tracking the Euro STOXX index. The iShares
Euro STOXX 50 provides exposure to 50 o
the largest companies across the eurozone.
It has gained 57 per cent over the past year to
1 March. But there are alternatives i youre
looking or broader alloca-
tions, or example to create
a simple but highly diversi-
ed portolio. The Pacicex Japan, North America,
Europe and Latin America
are available through
iShares, or you could ol-
low the FTSE Developed
World ex UK index through
iShares or the MSCI Emerg-
ing Markets index through
iShares, Lyxor and db-x.
At the top o the regional pile is the MSCI
World index, or which ETFs are available
rom iShares, Lyxor and db-x. This index
ofers exposure to around 1,700 companies in
more than 20 developed countries worldwide.
The iShares und does not hold positions in
the entire index, but takes the optimisation
approach by including a diverse mix o stocks
representing around 85 per cent o the market.
It has gained 65 per cent over the year.
However, some o the most popular geo-
graphical ETFs over the past year have been
single-country emerging market products.
Emerging market ETFs have seen greater
infows than all the local and developed world
ETFs combined over the last
year, says Hamid.
The choice includes Bra-
zil, Korea, Taiwan, India,Turkey and Vietnam, and
there are three broader
Bric packages rom iShares,
Claymore/BNY Mellon and
SPDR, but all oer dierent
weightings or country allo-
cations. One that has proved
particularly popular is the
iShares FTSE/Xinhua China
25 ETF, which gives exposure to 25 o the larg-
est 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 und, which also ollows an opti-
misation approach, tracks the perormance o
more than 50 diverse large and mid cap com-
Style ETFs Fixed interest ETFs Currency ETFs
Commodity ETFs Short ETFs Sector ETFs
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RegionalETFs
Single-country
ETFs
emgng mkt
eTFs v sngt nfws tn t nddvd wdeTFs mbndNizam Hamid
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8 Mo Obsv Exchange Traded Funds May 2010
panies representing around 85 per
cent o the Brazilian market. It has gained 116
per cent over the year.
StyleSome ETFs, labelled as style products, that
provide other tools to drill down urther into
specic market subsets. Its possible, or exam-
ple, to invest in indices created on the basis o
market capitalisation, dividend payment or
value or growth characteristics.
The STOXX indices oer a range o
European style ETFs, including MidCap,
Growth and Value, while the iShares FTSE
UK Dividend Plus ocuses on the perorm-
ance o the 50 highest dividend-paying UK
stocks, explains Nizam Hamid. The latter has
returned 55 per cent over the past year.
Fixed interestiShares dominates the xed interest ETF mar-
ket in the UK, with more than 25 products,including short, medium and long govern-
ment bond unds (most ocusing on eurozone
bond issues), infation-linked gilts and corpo-
rate bonds. Here, too, investors are able to drill
down to rene their investments, or example
iShares oers the iBoxx Corporate Bond ex
Financials ETF, which might be attractive to
anyone wary o the outlook or banks in the
light o the UK's ragile economic recovery
and wanting to exclude them rom a basket o
investment-grade UK bonds.
CurrenCieSCurrency ETFs have been around or
about our years, and have proved
very popular during the bear mar-
ket. They track currency indices
that aim to refect movements in
exchange rates between two currencies and
exposure to local interest rates. They are
swap-based products, backed by collateral
or saety, in eect guaranteeing investors the
return rom exposure to specic currency
movements without having to hold or trade
any oreign exchange. Theres no need to hold
a currency account and there are no utures
or orward contracts, so they
are a relatively simple way or
more sophisticated investors
looking or portolio diversi-
cation to play currency mar-
kets tactically. But theyre not
or novices.
The global currency ETF
market is dominated by US-
based Rydex and Powershares.
However, ETF Securities
entered the UK market at the
end o 2009 with 18 currency
ETCs categorised as exchangetraded commodities on the
London Stock Exchange. These provide long
or short passive exposure to G10 currencies,
(including the Australian dollar, Swiss ranc,
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 und accounts or 50 per cent o infows
to date in 2010 and the Australian dollar was
most popular as a long position.
CommoditieSOnly ETFs tracking the spot price o pre-
cious metals such as gold, silver, plati-
num and palladium can hold physical
assets. But these unds, especially
physical gold, have proved extremely
popular over the past year as investors have
looked to traditional sae havens in the ace o
stock market volatility and dollar weakness.
ETF Securities now holds around $9 billion
in precious metals, according to co-head o
European sales Scott Thompson, including
more gold than the UK government.
Other hard commodities are not practi-
cal to store (oil and gas or
instance), while agricultural
products tend to decay over
time, so these markets are
tracked via the Dow Jones/
UBS utures indices.
Its possible to ollow a sin-
gle commodity such as corn
or cotton, but Thompson says
many people preer to diver-
siy with a wide agricultural
basket or take a macro view
with a mixed commodities
ETF, as they dont have theexpertise to call individual
markets and these broad-based products are
less volatile than the individual commod-
ity unds. The main areas o interest, apart
rom gold, have been in oil and gas (although
within quite a limited price range, with trad-
ers switching to short positions as the price
reaches $80-85 a barrel), and agriculture.
Investors generally go or the ront-
month utures 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.
Its also possible to hedge against price alls
by using short commodity ETFs, and increase
your exposure via leveraged commodity ETFs.
Both are available through ETF Securities.
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If yOure keen tO
fOllOwthe rising ortunes
o a specic industry sec-
tor say nancials you can
do that by buying a sector
ETF. db-x has a range o sec-
tor products, including DJ
StOXX 600 Bas(which
gives exposure to the leading
banking companies across
western Europe) and DJ
StOXX 600 Isac, both
o which have more than
doubled in the past year.
Other sectoral ETFs
include healthcare, ood,
technology and industrial
goods rom db-x, while
iShares runs regional prop-
erty products ollowing the
FTSE/EPRA indices.
iShares also ofers sev-
eral thematic ETFs that
track the various indices
o the S&P Global The-
matic Index series,
which is designed to
provide investors with
exposure to a rangeo emerging invest-
ment themes. iShares
S&P Goba Ca eg
etf tracks the perormance
o 30 o the largest listed
companies involved in clean
energy technology, produc-
tion, or equipment provision.
It returned 33 per cent over
the year to 1 March.
Other S&P global the-
matic index themes in ETForm through iShares include
emgig Mas Ia-
sc, which ocuses on
30 large emerging market
companies in the transporta-
tion, energy and utilities, and
timb fos, which pro-
vides access to 25 timber and
wood product companies.
Its also possible to track
water, shipping, nuclear
energy and listed privateequity companies, as well as
Sharia-compliant companies
on a regional or global basis.
tHeMeSANDSeCtOrS
i s pssb b g-acsha gv ssva aa g-pspcv
sco thompo
iShares' Timber Forestry ETF tracks 25 wood and timber rms
For the environmentallyconscious, iSharesofers the GlobalClean Energy ETF
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Money Observer Exchange Traded Funds May 2010 9
F
or active traders wanting to
manage their position in the
markets eectively, leveraged
and short exchange traded
unds are among the options on
oer. 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 o European sales
at ETF Securities, anticipates that demand
is likely to continue this year in the current
uncertain market, as
investors look or the
return they need rom
occasional short-term
opportunities.
So how do they
work, and what are
their strengths? Aleveraged ETF tracks
an index like any other,
but uses borrowed
money as well as your
capital, with the aim
o increasing returns. ETF Securities runs a
2x leveraged product, which means that i
you put in 1 its matched by 1 o borrowed
money; then, or every 1 per cent o 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 o the
borrowed money as a single package to make
comparisons easier.
Its important to recognise that in the
longer run your leveraged ETF may not match
double the annual return or loss o 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 o 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 alling,
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 o leveraged
ETFs over other
leveraged products
such as utures or
options, where there is no cap on losses
and the higher levels o 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 or long-term buy and hold investors,
or indeed or anyone not actively monitoring
the market, either up or down.
They work very well in strongly directional
markets such as the strong rally rom March to
May last year: traders put stop losses in place
so that they could get out in a timely ashion,
Thompson explains. Equally, its possible to
get 2x short exposure through an ETF when
youre 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 portolio or
to speculate on the likelihood that a particular
market is going to all.
These are swap-based vehicles (see page
10) that produce a return guaranteed to mirror
the perormance o the market benchmark
which might be based in equities, property,
commodities or xed income (theres plenty o
choice). However, unlike conventional ETFs,
they correlate inversely with that perormance
hence the name. So i the benchmark index
rises, the ETF alls, and vice versa.
As with leveraged ETFs, one big attraction
o short ETFs over short investments involvingmargin commitments is that, although there
is no limit to the potential or loss on a short
sale because the underlying asset price could
in theory rise indenitely, 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
o asset classes, and there are no margin
requirements that restrict their use.
But both leveraged and short ETFs are
designed or sophisticated, active investors
who understand the risks involved and are
ready to manage their positions. The potential
risks or unsuitable users were sufciently
alarming or the Share Centre to withdraw
short and leveraged products last year, over
concerns that some investors buying them
didnt ully understand their complexity.
Complex
funds forthe savvyLeveraged and short ETF products
are not for the faint-hearted andtraps await the unwary
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LeveragedETFs workwell in strong
directionalmarketsScott Thompson
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We get under the bonnet o exchange traded undsand explain the ees you are likely to pay, their diferentstructures, and any risks involved
Buildingblocks
Most ETFs are
not particularly
complex
investments; they
amount to a kind o
hybrid combining
the strengths o
index tracker unds and traded shares. Like
an ordinary index tracker und, they aim
to replicate as closely as possible the index
ollowing a particular market or sector.
But unlike tracker unds, they are bought
and sold on the stock exchange, in the same
way as a single company share is. So in other
words, youre buying the perormance and
diversifcation o an entire market in a single
package.
The range o 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 or instancecertain style-based ETFs providers may
make their own indices by ltering down an
existing index.
As Nizam Hamid, head o sales strategy
at iShares, explains, index providers create
their own sets o requirements to dene an
index universe. For xed 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 o market capitalisation, theme, sector
or geographical region.
Thus, its possible to buy equity ETFs
or single countries such as South Arica or
Turkey; regions such as Pacic ex Japan;
small or large caps within specic countries
or regions; market sectors such as banks or
basic resources; and themes/styles such as
global inrastructure, value investments and
clean energy. Other options include ETFs
o commodities such as corn, iron and zinc;
currencies, and bonds and gilts.
For investors, the attractions o these
unds hinge on several key considerations.
First, as weve seen, they provide instant
diversication, and a manageable building-
block means o putting together a truly global
portolio.
They can also be a simple, low-cost way
o getting exposure to more esoteric and less
accessible markets that are not otherwise
available in pure orm to retail investors. For
instance, ETFs tracking the Brazilian stock
market have been very popular recently on
the back o the countrys thriving economy;
the nearest unit trust or Oeic equivalent
would be a Bric or Latin American und.
Second, they are easily dealt and liquid.
They can be traded at any time o day in the
same way as a share; i you already have a
sharedealing platorm in place, this makes
the whole process very quick.
As Graham Spooner, investment adviser at
broker The Share Centre, explains: Its 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 i you have
to wait until the next day or your trade to go
through, the price may have moved.
Thats not a serious consideration or
buy-and-hold investors, but it does open
the door to more active traders who want,
or example, to take a short-term position in
a particular market sufering a temporary
setback and likely to recover in the coming
hours or days.
COST COnTrOlThird, ETFs have very low running costs
compared to unds, because no active
manager is involved.
According to iShares, the average total
expense ratio (TER) o a bond ETF is 0.25per cent, and or an equity ETF its 0.32 per
cent. Even the standard index tracker unds
available through the retail market have
average TERs o 0.8-0.9 per cent, according
to Investment Management Association
gures, while TERs or actively managed UK
equity unds 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 o dealing. Through an
online broker you should be able to carry out
execution-only trades or around 10 to 15.
On a 20,000 trade, 15 makes no perceptible
diference, but a 15 dealing ee on a 500
trade amounts to an extra cost o 3 per cent.
ETFs aetaspaet you catade miuteby miuteGraham Spooner
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Money Observer Exchange Traded Funds May 2010 11
Another actor that investors should be
aware o is that not all ETFs work in the
same way. Some, reerred to as cash-based
unds, do buy all o the securities in the
underlying index and hold them as und
assets a process known as ull replication.
But or some cash-based ETFs it may not be
practical to hold every single constituent o
the index. In these cases the ETF provider
takes a representative sample
o the index constituents and
tracks their perormance. Thus,
the iShares MSCI World ETF
holds only 700 securities o the
1,800 in the index itsel.
index mimicsSome ETFs do not hold physical
assets at all, but instead use total
return index swaps to mimicthe perormance o 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 portolio with
the return on the index to be tracked. In
eect, says iShares, investors are buying the
perormance o the index, not the physical
securities it contains'.
Swap-based ETFs can be more tax-
ecient in some cases, and are also useul
when it comes to less easily accessed markets
such as commodities. They can also reduce
tracking error the (usually) small but
inevitable underperormance o any index
tracking und relative to the index itsel
because the ull index return is guaranteed by
the counterparty to the swap.
Against this, swap-based unds are less
transparent than cash-based equivalents
because they dont actually
hold the physical securities
o the index. Moreover,
there is the added risk that
the counterparty may ail
to honour its obligations,
although or unds marketed
within the EU measures
have been taken to limit the
counterparty risk involved.
It is important to assess allETF 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 o investment, you need to
take the trouble to understand the rudiments
o what youre actually buying, how they ft in
with the other elements o your portolio, and
where the potential hazards lie. Then youre
ready to go.
A alleTF prouta trutura ah uquNizam Hamid
Visit MoneyObserver.com to view a range of
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manage their funds to gain top performance.
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Visitwww.moneyobserver.com and see for yourself
Bruce Stout
Mark Mobius
Income Roundtable
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12 Moey Observer Exchange Traded Funds May 2010
By using ETFs alongside some actively managedfunds you can invest in the more inaccessibleEuropean and emerging markets and gain easyentry to alternative asset classes as well
Core andsatellite ofyour world
One o the beauties o
ETFs is that they oer
such a broad spectrum
o access at the one
end, ull 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 o
investment ail to reach.
As well see, nancial planners, especially
those with a strong asset allocation bias,
make use o that fexibility in a number o
strategic ways within client portolios. There
are various nuances, but on the whole, they
tend to be employed in one o two key roles.First, they may be employed as a low-
cost core holding in some or all o 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 specic
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 unds.
Passive/active relative risksOne approach is that ollowed by Richard
Gough, a nancial planner and director
at Castle Court Consultants. Were asset
allocators rst and oremost, so we take the
view that most returns come rom being in
the market rather than rom being invested
with a particular und, he explains. ETFs
provide a low-cost route in, and, importantly,
they remove the risks involved in trying to
predict which manager will outperorm the
market on a risk-adjusted basis.
But Gough is not a slave to the tracker
approach. He uses ETFs as a deault position,
which basically means wherever its the
most eective way o getting risk-adjusted
exposure. Where he doesnt eel comortable
in selecting an ETF or one reason or another,
he uses an actively managed und.
He explains: Its 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 i
we were currently investing in the US Id be
happy to use the S&P 500. The same goes or
Japan and the Far East theres a clear-cut
choice o ETFs romiShares. (Gough sticks
with this range because they are cash-based
and work best or wrappers such as oshore
bonds.)
However, he continues, Europe is a
dierent matter because there are so many
country/sector/market cap indices and
ETFs to choose rom. Its arguably less
alinor
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g
ic
renc
iesFi
xinte
Levera
gCo
m
AnnA SOfAt makes
the interesting point
that she has used
swap-based ETFs (see
page 10) or clients
with ethical concerns,
who wanted to buy
into international mar-
kets including the Far
East, China and Brazil,
but didnt want to put
their money into cer-
tain industries within
it tobacco companies
or arms manuactur-
ers, or instance.
We had no way
o fltering collectives
and individual shares
presented too high
a risk, she explains.
This way, they ben-
efted rom any over-
all uplit in the market
but didnt actively
support the unac-
ceptable elements
within it.
EtHICAL ISSUES
ann sofu wp-bd etFfor ln
wh hlonrnAnna Soat
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Money Observer Exchange Traded Funds May 2010 13
risky to appoint an active
European equity und
manager, so that is what
we do, on the basis o
actors such as consistency
o perormance, ratings and experience.
For emerging markets, too, Gough uses an
actively managed und, this time alongside
an ETF.
Commodities are another area or
active management, though on dierent
grounds. With a commodity ETF, you can
make a call on a specic commodity price,
and thats speculation rather
than investment. But blended
commodity unds tend to bevery bland so we dont bother
with them. Any xed-interest
allocation, perhaps surprisingly, is
also actively managed, but
with strategic bond unds that
enable the manager to move
across the bond and gilt
spectrum as necessary. Its a
very fuid and strategic market,
comments Gough.
InaccessIble investmentsAlan Dick, managing director o FortyTwo
Wealth Management, takes a similar tack,
taking broad market positions and using
passive investments or the entire portolio,
except where theres no way to achieve what
we want.
However, Dick
makes his choice rom
both index tracker unds and
ETFs, selecting on the basis o both
cost and reliability. Currently the bias is
towards trackers. At the moment some o the
institutional unds, or instance some L&G
trackers, are cheaper, so were tending to use
ETFs only in those markets where a suitable
und isnt available.
So, or example, he is able to access
emerging markets using a Dimensional
tracker. In this case he preers it to the
iShares MSCI emerging markets
ETF, partly because the latter
contains lots o stu in Russiaand elsewhere that you wouldnt
want to touch with a barge
pole. The Dimensional und, in
contrast, uses a screening process
to create a more desirable index.
As a consequence, at the
moment only two ETFs currently
eature in his portolio both or
property coverage, which is not
oered through index trackers. Were using
the iShares FTSE/EPRA Developed Market
Property Yield and UK Property ETFs, says
Dick. The choice o which one to include in
a portolio is based on tax considerations.
He preers the idea o global diversication
available rom the ormer but it is a non-
distributor und, which means gains are
taxed as income at up to 50 per cent,
so he only utilises it
within a tax wrapper such
as a pension or Isa. In
contrast, the UK und has
distributor status, so that
gains are taxed as capital
gains at only 18 per cent.
core/satelliteRebecca Taylor, managing director o
Dunham Financial Services, is another
nancial planner with a passive investment
bias. She uses ETFs or the core long-term
holdings o most clients, on the grounds
that active managers rarely beat the market
over that time rame. That includes Europe,despite the plethora o ETF oerings
available. Its a complex area, so we need
to be quite specic; we use a broad spectrum
o holdings to mimic the main markets,
she says.
Smaller satellite holdings tend to be
alternative assets that add diversication
and its here that shes prepared to accept
more variety in the type o investment vehicle
selected, depending on whats available.
We may include active unds or example,
we use the EEA Lie Settlements und and
JPMorgans Natural Resources und, and
we also use an active und manager or
hedge unds. But there are other alternative
investments that happen to be easy to access
via ETFs, such as property, gold and private
equity, she adds.
With mmdityeTF yu mk piRchrd Gough
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14 MoneyObseve Exchange Traded Funds May2010
alinor
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iesFi
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m
Mature marketsEven IFAs who generally avour actively
managed unds as the basis o client
portolios may justiy the use o ETFs or
certain core markets basically those that
are so thoroughly researched and accessible
that active und managers nd it hard to add
much value.
As Darius McDermott, managing director
o Chelsea Financial Services and a rm
believer in the long-term advantages o the
best actively managed unds, explains: I would
consider using ETFs in areas such as the US
large cap market, where its very dicult
to identiy active und managers that are
consistently able to outperorm the market.
annual rebalancingSome nancial advisers and planners are
attracted by ETFs advantages o liquidity
and simplicity o trading, utilising them
as a uctuating bufer zone around a core
holding o long-term unds (active or passive)
invested in the same assets. Because ETFs are
so easy to trade on the stock exchange, any
rebalancing necessary to the portolio can be
done through them, rather than by buying or
selling the unds themselves.
Nizam Hamid, head o sales strategy
or iShares, gives an example. I you had a
particular asset class accounting or a chunk o
your portolio, 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
could easily rebalance your allocations.
Stuart Fowler, managing director o IFA
rm No Monkey Business, is one such adviser.
For long-term equity holdings that are
unlikely to be touched or 20 years plus, we
buy institutional tracker unds because they
are the cheapest option, he explains. But the
rebalancing stock is held in ETFs on a broker
platorm. As individual markets move against
each other, our weightings change. Theres
no xed mix, but we can make all our
adjustments very easily via ETFs.
short-term tactical holdingsFinancial advisers and planners are looking
at long-term strategy and thereore tend toleave tactical dodging and weaving to the
day traders and active investors who are
monitoring the market on a close basis. But
there may be occasions when a relatively
short-term position is justied or clients,
as Anna Soat, managing director o Addidi
Wealth, explains.
Last year, when the FTSE was down to
around 4000 and interest rates had allen to
nothing, there was a big question or some
clients over what to do with their money.
We put some o 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 Soat, but in the event one client has lether cash invested, drawing prots rom time
to time as an income stream.
Povides
ETF Secities020 7448 4330,www.etsecurities.com
iShaes 0845 357 7000,www.uk.ishares.com
db-x 020 7547 1747,
www.dbxtrackers.co.uk
Lyxo www.lyxor.com
Poweshaes www.inve-scopowershares.com
Backgond infomation
Moningstawww.morningstar.com
LSEwww.londonstockex-change.com
IFAs/bokes
Selftade 0845 070 0720,www.seltrade.co.uk
Towe Hill Associates0208 891 6375,www.towerhillassociates.com
Yellowtail FinancialPlanning020 7933 8671,www.yellowtail.co.uk
No Monkey Bsiness020 7736 2434,www.nomonkeybusiness.co.uk
Addidi WealthManagement020 7060 1200,www.addidi.com
CONTACTS
WHILE ASSET ALLOCA-
TOrS MAY uSE ETFS
mimicking the broader indi-
ces to gain the kind o core
regional exposure they need
at low cost, there is also an
argument or dipping into
the wide and rapidly grow-
ing range o more esoteric
ETFs available, in order to
access specic interest-
ing single country, style,
thematic or commodity
markets.
Drilling down in this
way tends to be avoured
by more active or sophis-ticated 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 o inow over the past
year into specic emerging
market countries, including
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 difcult to access oth-
erwise or those who simply
want to tap into the growth
trend rather than commit-
ting themselves to the value
judgements o a particular
active manager. ETFs lend
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, manag-
ing director o IFA Tower
Hill Associates, observes:
Theyre a great tool or
detailed granularity, i you
want to home in on the mar-
ket growth in a specic sec-
tor, commodity or country.
DIPPING INTOESOTErIC MArKETS
W v
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