Trading places

With commodity prices grabbing the headlines, the public will have a growing appetite for exchange traded funds. Sonia Speedy says high earners should not be too adventurous

With everything from livestock to Far Eastern property now covered, the market for Exchange Traded Funds (ETFs) and Exchanged Traded Commodities (ETCs) has seen not only significant growth, but also colour added in recent years.

For senior executives and high net worth clients ETFs can offer an effective financial planning tool – if the temptation to delve into some of the more obscure funds can be avoided.

At the end of the first quarter this year the number of ETFs around the globe had hit 1,280, with total assets under management (AUM) hitting $760.80 billion (£385.6 billion), the Morgan Stanley Exchange Traded Funds – Q1 2008 Global Industry Review reveals.

In Europe alone there were 479 ETFs, worth $145.2 billion, (£73.6 billion), with the report showing a year to date increase of 13.5 per cent in European AUM. That comes against a fall in the MSCI Europe index of 16.2 per cent in dollar terms.

Robert Brown, chief executive of Pan-Asset Capital Management describes himself as an “evangelical enthusiast” for ETFs, with his investment management firm utilising them as the building blocks for client portfolios.

“I think these things are going to absolutely sweep the savings scene over the next few years. At the moment they’re one of the City’s best kept secrets,” he says.

He expects to see the number of ETFs owned by private individuals increase significantly over the next few years, citing the simplicity, flexibility, transparency and liquidity of ETFs, in conjunction with the cost-effectiveness, as the major draw cards.

Brown uses the example of the Barclays Global Investors’ iShare which tracks the MSCI world index, saying that while it has a fee of only 0.5 per cent, retail unit trusts can cost up to 1.5 per cent, with upfront fees on top.

Gavin Haynes, managing director at Whitechurch Securities describes ETFs as offering a low cost, passive management approach to gaining exposure to a sector or a market. “They have the benefits of low cost and the fact you get total correlation with the market or the area that you choose to invest with. But obviously you don’t get any active management with them,” he says.

He adds that ETFs can also provide access to investment areas that can be difficult to access otherwise for those with more specialist portfolios, including commodities such as gold.

“ETFs provide an excellent way to get exposure to what’s happening with the gold price without having to actually physically go and buy blocks of gold,” Haynes says.

iShares, Barclays Global Investor’s ETF provider, is described as the world leader in ETFs and the company’s wealth management principal Dee Brown says ETFs have been proving a particularly popular investment tool in the volatile markets currently being experienced. “What we’ve noticed is, when there is volatility in the general market, ETF assets increase – not only ours, but everyone’s,” he says.

Invesco PowerShares describes itself as a specialist provider of fundamentally-weighted exchange-traded funds and its head of investing institutions Tim Mitchell believes passive investing is still mistrusted in the UK. “The idea that you can just write a computer model and it creates alpha is something which many people find difficult to grasp,” he says. “But the reality is that the majority of active funds run by individuals underperform the benchmark,” he says.

Pan-Asset Capital Management looks to build its investor portfolios entirely of ETFs, using conventional funds such as global, UK and US equities as the core, with more “interesting” ETFs as satellite investments. “Our argument for doing that is the performance of those unit trusts and Oeics and so on is significantly behind the index, largely for cost reasons,” says Brown. “We say the ETFs are a much more cost-effective way of implementing a strategy and increasingly there are ETFs in areas where you can’t get unit trusts.”

Hargreaves Lansdown head of research Mark Dampier suggests ETFs can be used either as a portfolio core or as satellite investments. “I could buy a commodity basket, if I was just wanting to get more exposure to commodities as a manager, or wanted my investor to, that would be a quick, easy way to do it and I can buy or sell on any business day and I know what I’m getting,” he says. “You could do it as a satellite, or just as easily as a core, because now they offer (ETFs) across the board.”

iShare’s Dee Brown suggests ETFs can be used to help wealthy executives achieve greater diversification within their investment portfolios – particularly if they have heavy exposure to the company they work within.

“If a person has a concentration in the telecoms industry, or the utility industry, ETFs – because of their modular and building block attributes – will allow you to build an allocation around that exposure,” he says.

ETFs can also play a useful role within corporate pensions, Dee Brown suggests. “The purest way to implement the asset allocation you’re after is really through exchange-traded funds,” he says.

Pension funds can use ETFs as the “broad based” core investments, with hedge fund and speciality managers around it as satellites in a bid to add alpha, he says. “The combination of the two reduces risk and gives you a better risk-return ratio and lowers your costs dramatically in some cases. That’s how pensions have been using, and are beginning in Europe, to use ETFs,” iShare’s Brown says.

The most obvious downside of using ETFs, however, is that whilst the risk of under performing the index is eliminated, so too is the opportunity for out-performance.

“People who have experienced stock picking as a triumph of hope over experience – which I think is most people over the years – will like ETFs,” Pan-Asset’s Brown says. “But if you think no, I can find a guy who can out perform, then ETFs would seem very bland to you,” he says.

Meanwhile, Dampier cautions advisers and investors about some of the more niche ETFs being launched. “It seems to me the business model with ETFs is to launch as many esoteric ‘sex and violence’ types of things as you can that grab the headlines and suck a load of people in,” he says. “I’m not against the ETF concept – the idea of buying baskets of bits and pieces is fine. But I would caution people about what is tending to be happening, because I think a lot of people are almost day-trading ETFs at the moment.”

Pan-Asset’s Brown points to other factors that need to be considered with the use of ETFs, such as their tax treatment. Typically ETFs are set up in offshore locations and while there may be no tax due in the offshore environment, the tax treatment back in the UK can vary, dependant upon whether or not the ETF has HM Revenue and Customs distributor status.

“If the Inland Revenue accords an offshore fund distributor status, it means it’ll be taxed like a normal UK equity. But if it doesn’t have distributor status, the Inland Revenue takes the view that the fund is effectively rolling up income into capital gain and therefore taxes the gain at income tax rates,” he says.

This can make a big difference to higher rate tax payers, particularly since the introduction of the 18 per cent flat Capital Gains Tax (CGT) rate.

While opinions differ on the extent and exact use of ETFs within client portfolios, there is no doubt they are increasingly finding a place within them, as Europe enjoys the highest ETF growth rates in the world.

Mitchell believes the concepts of fear and greed and the “huge biases” currently evident in the market – from commodities to financials – is throwing up “interesting” investment opportunities, which just such a passive approach can help to capitalise on.

He says: “It can get you away from the noise of the market and you can stay focused. There should always be a place, I think, for passive investment as well as active, in any portfolio.” n

Ways ETFs track indices • Replication: Replicating the index explicitly by buying the same investments as those in the index and in the same proportions, rebalancing whenever the index is rebalanced.• Optimisation: Investing in a subset of the index components, the returns of which are considered as likely to reflect that of the index as a whole. Includes the risk that this judgement can be inaccurate, increasing tracking error.• Synthetic replication: The elements used to track the index may or may not be part of the index itself. The return from the shares purchased is then swapped with the sponsoring investment bank for the return of the index. This method introduces an element of counterparty risk.

Source: The Way of the Future, Investment Management for Private Wealth and Charitable Endowments using Exchange Traded Funds, Pan Asset Capital Management

ETFs – exchange and rewind

Jason Butler, branch principal at Bloomsbury Financial Planning makes use of Exchange Traded Funds (ETFs) as a way of gaining low cost exposure to Butler: Uses ETFs where appropriateasset classes that can otherwise be difficult to access.

“We don’t use ETFs exclusively, we only use them where basically they offer the lowest cost, best representation, for a given asset class,” he says.

“In our case, out of the 14 funds we use, we only use ETFs for commodities exposure and for index Real Estate Investment Trusts (Reits) exposure and that’s because there is no other alternative that can offer the same asset class exposure at that cost.”

Butler also believes that the diversity of some ETFs being released now is starting to border on the ridiculous. “There are new ones coming out every day. But, for instance, we’re still waiting for an FT World excluding UK ETF – there isn’t one of those – but there’s one for Taiwan Smaller Companies – which no-one needs.”

Butler describes ETFs as a welcome development in the market, but suggests they need to be used as part of disciplined asset allocation rebalancing and not as an active asset allocation tool. “When you do use them, you need to use ETFs that cover meaningful asset class areas and that do it well, so that even if they are cheap, they replicate the asset class that you actually want properly.”

Bloomsbury Financial Planning makes use of the Barclays Global Investors’ (trading as iShares) EPRA/NAREIT ETFs for its UK and global property exposure. For tracking commodities, it uses the Lyxor ETF Commodities CRB, a French Sicav.