With competition increasing and costs coming down, it is hard to see the downside for those embracing ETFs. Christopher Aldous, managing director at Charles Stanley Pan-Asset, explains.
The dramatic increase in the range of exchange traded funds (ETFs) on offer and the sums invested in them has taken the investment industry by surprise.
As of November, there were 1,338 ETFs listed in Europe, with total assets under management (AUM) of €283bn, compared with just 163 ETFs worth €99bn in 2008.
And this is a market still very much in its infancy: in the US, total AUM in ETFs has reached $1.5trn. ETFs are easy to use, low cost and highly diversified – an attractive combination which has clearly caught the attention of investors on both sides of the Atlantic.
The highs and lows of embracing exchange traded funds
Let’s remind ourselves of how they work. All ETFs are designed to be highly efficient index trackers, but can use two very different processes to achieve this: either via synthetic or physical replication.
Synthetic ETFs use swaps in their mission to get the most accurate index return, while physical ETFs only invest in baskets of the shares or equities that already feature in the indices they track.
In this regard, physical ETFs are very much like traditional passive funds, while synthetic ETFs are more complicated. The added complication of swaps is not necessarily a problem, but it can leave investors with a few headaches as they attempt to quantify the counterparty risk involved.
For those who prefer to keep it simple, there are thousands of physical ETFs, meaning that, for most portfolios, there is no need to experiment with synthetics.
To invest, you buy shares in the ETF listed on the stock market, just as you would for an individual company share. And just like a share, ETFs are highly liquid. Unlike an ordinary share, however, shares in ETFs can be created or redeemed by the ETF provider to meet demand.
This means that, while shares in an ETF on the secondary market may vary slightly from the net asset value (NAV) of the underlying shares or bonds of the index being tracked, significant discrepancies rarely last for long.
For the most part, ETFs trade very close to NAV. Just like traditional index-tracking funds, ETFs use securities lending to reduce the cost of investing and improve performance. Unlike traditional funds, many physical ETFs are fully replicating, which means they own the full index of shares they track, which makes them more efficient trackers even though their published costs may be higher.
In fact, measuring the effectiveness of ETFs is not as obvious as you might think. We monitor ETFs across dozens of data points but the single best way to assess them is by calculating ‘tracking difference’.
This is the difference in performance between the ETF and the index it tracks. Investors might expect this number to be very similar to the ongoing charge (the measure that has replaced the total expense ratio) of the fund; however, in practice, tracking difference can vary significantly, both positively and negatively.
The cheapest fund in terms of ongoing charge is not necessarily the best tracker. In fact, if a cheap ETF is keeping a lid on costs by only tracking part of its index, then its tracking difference can be high. Tracking difference is the number that matters most as it is, effectively, the true cost an investor pays and ultimately determines the return of the tracker.
The other advantage of ETFs is the wide variety now available. Proliferation of products may not always be applauded but, in this case, investors have an abundant choice of asset classes to invest in via ETFs, which is good news.
Even the most sophisticated asset allocations can be built exclusively using physical ETFs, which offer access to a full spectrum of global and emerging market equities, bonds and property. For the more discerning investor, ETCs offer access to commodities of all shapes and sizes, and synthetic ETFs can be used to invest in less liquid indices, such as those tracking hedge funds.
For some investors, however, ETFs remain out of reach. Those who do not have access to share trading or are not comfortable with traded index funds will remain restricted to old fashioned unitised pool funds.
But with competition increasing and costs coming down all the time, it is difficult to see the downside for those who are prepared to embrace ETFs. Investors often fear what they do not understand – for good reason.
However, it is important to remember that many ETFs are just ordinary funds which comply with UCITS rules but have the advantage of a stock market listing as well. It is worth making the effort to understand ETFs better. A little education certainly pays off.
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