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The growth in the Exchange Traded Funds (ETF) sector has been remarkable since their introduction in the USA in 1993. The number of ETFs in issue continues to grow every year with 8845 ETFs now available to UK investors. These ETFs track the performance of nearly every stock market, sub sector stock market, bond market and commodity market across the globe.
Just like index tracking passive funds, ETFs offer investors a single investment that replicates the component assets and performance of a selected index. ETFs provide diversification across an entire index guarding against single stock volatility. Management fees are typically lower due to the simple index replication nature of investment research. The index approach benefits from low operating costs and competitive performance when compared to the majority of actively managed investment funds over time.
Exchange Traded Funds (ETF) as the name suggests are funds that trade on a stock exchange. ETFs are pooled investment funds that are regulated under the European Union’s UCITS regime allowing ETFs to be bought and sold on all European Stock Markets. ETFs are continuously priced open ended index funds and as such trade throughout the day. An ETF can be purchased at a known price at any time instead of only once a day like OEIC and Unit Trusts. The open ended nature of an ETF also allows for the creation and redemption of shares in order to meet investor demand. ETF trading settlement times are quicker. A sell and buy strategy can be simultaneously executed keeping investors in the market. OEIC and Unit Trusts investors have to wait until a sale is settled to reinvest which usually means four or five days out of the market.
Due to these characteristics ETFs uniquely provide two sources of liquidity. The primary market offers liquidity through the ETF issuer and Authorised Participants creating and redeeming ETF securities to meet investor demand just like other open ended funds. The secondary market offers liquidity through tradable securities on the stock exchange just like closed end funds This double layer of liquidity makes ETFs easy to trade and therefore usually track very closely the value of the underlying index.
Traditionally in order to replicate an index such as the FTSE 100 Index, an index fund would purchase all the underlying physical securities in line with their index weighting. However, this is not always practical so a fund may just buy a range of selected securities. This process is called optimisation and is used when an index is hard to replicate. A fund will instead purchase a representative subset of securities, usually ones that have a strong correlation with the index.
Retail index tracking funds are usually purchased from a fund manager via an investment platform. ETF trade on a stock exchange and therefore are available to buy or sell via a stockbroker or stockbroker platform at market prices. The ETF share price is available throughout the day and is influenced by the share price movement of the underlying securities, currency exchange rate movement for international index funds and investor demand.
Any ETFs listed on the London Stock Exchange can be used as an asset within an ISA, Pension Fund or Life Insurance Offshore Bond.
ETFs often benefit from lower operating costs and expense ratios compared to OEIC index funds. However, as ETFs are purchased as a security that is traded on a stock exchange they carry additional up front stockbroking purchase costs and a trading spread. Therefore, the holding period of an ETF becomes important in order for the lower annual management costs to overcome the transactional charges. For this reason, ETFs are usually more cost effective for larger lump sum investment. Investors making regular or frequent small contributions would be better suited to OEICs or Unit Trusts.
Investors seeking to create a well-diversified portfolio may be suited to a broad range of ETFs that track the indexes of differing asset classes, sectors or regions. ETFs often hold hundreds or even thousands of individual securities so a single ETF can instantly diversify a portfolio into a particular asset class, sector or region into which the ETF invests.
There is no significant difference in taxation between an ETF and an OEIC, unit trust, investment trust or a share. Realised capital gains count against the capital gains allowance. Dividend income will be taxed as income.
For EU UCITS purposes ETFs are often domiciled in Ireland. An Ireland domiciled ETF that has “reporting or distribution status” for tax purposes is treated for capital gains in the same way as other collective investment funds.
Normal due diligence processes apply to the selection of an ETF just the same as any other fund we would recommend. Unfortunately, the current level of institutional due diligence reporting is not as extensive as it is for OEICs, unit trusts or investment trusts.
It is common for an ETF to be selected based upon the relevant index and the operational charges. However, such features as tracking methodology and accuracy, the stability and expertise of the provider, excess return and tracking error as well as the security lending policy should be considered.
Annualised fund returns are amongst the first measures considered when evaluating investment funds. How well an index fund performs against both its benchmark index and competing products is also important. The excess return tells an investor the extent to which a fund has outperformed or underperformed against its benchmark index. Tracking error is calculated as the annualised standard deviation of excess return. While excess return measures the extent to which an index fund’s returns differ from that of its benchmark, the tracking error indicates how much variability exists within the funds excess return data points.
If total return is the primary objective then excess return is more important. However, if a consistent performance that matches the index is important then tracking error is relevant. The best scenario would be an ETF with both a high excess return and a low tracking error.
Securities lending is the practise of temporary transferring or lending a security by the ETF manager to a third party in exchange for cash that can produce income for the lender. This can be an attractive source of revenue. However, for what is a relatively risk free way to increase returns there can be pitfalls in the form of counterparty risk.
Management fees for ETFs are lower than actively managed funds as an ETF simply replicates an underlying index and consequently its performance rather than analysing individual stocks to outperform the index. An ETFs total expense ratio (TER) is typically in the range of 0.1% to 0.6% of asset value per annum. Typically, a portfolio of ETFs would cost an average of 0.3% per annum. Added to this cost are the platform custodial costs of around 0.35% of asset value per annum and the investment management fee. The investment management fee is dependent upon the portfolio investment and varies between 0.35% per annum and 0.75% per annum.
The world’s most advanced market for ETFs is the USA. In the US, ETFs are widely used by institutions, advisers and private investors. With the growth in ETFs we have also witnessed the growth of ETF strategists. These wealth management firms have developed new and differing uses and styles of ETF investment to generate alpha returns form these passive beta products. ETF strategists are overtaking traditional stockbroking firms as the main stay of retail wealth management in the USA.
We, at Estate Capital, wish to be at the forefront of these new ETF strategies in order to improve the range of investment options we offer. With this in mind we are currently investing in new and unique academic research into financial forecasting and market timing strategies in order to launch a series of our own ETF strategies in 2018.
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