Exchange traded funds are a fairly new arrival on the investment scene, offering investors and advisers the chance to achieve consistent benchmark performance while keeping costs to a minimum.
Index funds are now a mainstream investment approach, their cost-efficient, risk-controlled nature making them an ideal building block for many an investor's portfolio.
The arguments in favour of tracker funds are well known: they offer well-diversified exposure to equity markets and avoid stock-specific risk; low portfolio turnover and the absence of highly paid star fund managers keep costs to a minimum; and consistent benchmark performance, as it represents an average, means better performance than the average active manager.
However, the debate has gone far beyond the issue of purely active versus indexed. Most now see the two approaches as complementary rather than mutually exclusive. The common terminology used is core-satellite: build a low-risk, low-cost core to a portfolio using index funds, while pursuing higher returns with more aggressive, satellite active funds and individual stock positions.
Exchange traded funds (ETFs) are an ideal investment tool for core-satellite investing and for a host of other investment strategies. For the most part, they are structured as open-ended investment companies (Oeics) in the UK. They offer exposure to an entire index in just one share, similar to a unit trust, but unlike a unit trust, ETFs trade like normal shares any time the market is open.
ETFs are available covering individual countries, economic zones and industry sectors. Their unique structure (market participants such as Morgan Stanley or Goldman Sachs trade underlying blocks of index components, upon which the shares are based) means they trade almost exactly in line with net asset value (NAV) and do not suffer from the premiums and discounts that investment trusts typically face.
ETFs can be bought as part of an Isa or an existing Pep, and unlike other shares, including investment trusts, are exempt from stamp duty in the UK. The key benefits offered by ETFs are flexibility, cost-efficiency and transparency.
Although financial advisers may talk about strategies such as core-satellite, sector rotation and tactical asset allocation, there are a number of obstacles that prevent individuals implementing them efficiently.
Taking core-satellite as an example, the theory behind this is that it can be tailored to meet an individual's specific risk requirements. In the past, it might not have been so simple ' an investor might invest 10% of their portfolio in a bond fund, 80% in a conservative, actively managed equity fund and 10% in a few speculative stocks or a high growth fund.
The problem with this scenario is cost. Not to mention that you might be paying a 5% up-front charge on each fund, you would be paying annual management fees of about 1% for your bond fund, roughly 1.5% for your core equity fund, and perhaps something much higher for your high-risk investments.
It is therefore little wonder that many investors have opted for a balanced fund and let their fund manager get on with it. But the problem with balanced funds is that what suits a 55-year-old looking for a place to invest profits from company share options will not suit the 30-year-old who has just made their first million. Other things being equal, the latter should be prepared to take much higher risks.
By their nature, ETFs are eminently flexible, allowing individuals to buy and sell at any time to suit their own changing risk profile. Crucially, they are also low cost ' the up-front cost is the same as buying ordinary shares and they have annual management fees as low as 0.35%. With costs at this kind of level, investors are able to seek higher returns elsewhere, safe in the knowledge that they are not handing back any outperformance gained in the form of high management fees.
There is also a range of sector ETFs trading in the UK that allow investors to react to specific market trends and can form satellite components of a portfolio in diversified and cost-efficient manner. These are also flexible enough to be used for other investment strategies.
ETFs are relatively new on the European investment scene, only reaching the UK in April 2000. Since their launch, they have seen huge success, assets under management for European ETFs grew from $675m to $5.6bn in 2001 alone, according to Morgan Stanley, despite adverse market conditions.
As for the future of ETFs, we see demand growing exponentially. On top of the benefits of flexibility and cost-efficiency, there are factors that should aid their success. Globalisation and the creation of European economic and monetary union are changing the way investors view their portfolios. These factors have eroded one of the traditional routes to obtaining diversification, investing in different countries.
Country-specific benchmarks are increasingly moving in line with each other.
However, the forces driving the correlated movement of national stock markets are also creating a new source of potential diversification ' sectors. The majority of industries can now be considered as truly global. For example, the share price of a UK-based maker of semiconductors will depend far more on the global chip market than it will on the fact the firm is located in the UK. Furthermore, the movement of semiconductor stocks will only bare minimal resemblance to the movement of other industries such as healthcare. The same is true of other sectors like energy, banks, materials and media .
ETFs once again provide a solution. They are flexible and cheap enough to allow the individual investor to explore these sources of diversification in a risk-controlled manner. In the past, if an investor wanted to devote 8% of their portfolio to the European pharmaceutical sector, they would have to place their money in just a few large stocks (diversifying more than this would run up impractical trading costs).
ETFs are low cost ' the up-front charge is the same as buying ordinary shares and they have annual management fees as low as 0.35%.
ETFs are relatively new on the European investment scene, only reaching the UK in April 2000.
ETFs can also allow investors to explore sources of sector diversification in a risk-controlled manner.
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