guide to exchange traded funds

8/9/2019 Guide to Exchange Traded Funds

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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


4/12

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


5/12


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


7/12


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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10 Money Observer Exchange Traded Funds May 2010

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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


9/12


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

interviews where editor Andrew Pitts questions

leading fund managers and industry experts to

gain an insight into their views on the major

markets and sectors and to understand how they

manage their funds to gain top performance.

These fascinating insights are freely available

to all Money Observer readers.

Visitwww.moneyobserver.com and see for yourself

Bruce Stout

Mark Mobius

Income Roundtable


10/12

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

alins

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


11/12


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


12/12

14 MoneyObseve Exchange Traded Funds May2010

alinor

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xinte

Levera

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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

w v p y pf mnz hd

guide to exchange traded funds

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