Although underused by retail investors, ETFs offer a number of benefits - greater portfolio diversification, liquidity and cost-effectiveness among others - that have already proved useful tools for multi-managers
The first Exchange Traded Funds (ETFs) appeared in the US in 1993 and targeted both pension funds and retail investors. Since then the range of funds and the markets covered have expanded greatly, covering equities, bonds, real estate and commodities. Despite 28 April 2006 marking the sixth anniversary of the launch of the first ETF in the UK, and the obvious attractions of these investments, they feature in relatively few retail investor portfolios. To the multi-manager, however, ETFs have proved useful tools in portfolio management. An ETF is essentially an index-tracker fund, packaged in a way that combines the most investor-friendly attributes of both open-ended funds and investment trusts - principally efficient pricing and dealing.By purchasing a share in an ETF, an investor gains exposure to a basket of stocks held in the same proportion that they represent in a given index. The performance of the ETF should closely match that of the underlying index, while management charges and tracking error will give rise to modest deviation from the index return.ETF charges are attractive in relation to other collective investments. As index trackers they enjoy lower management fees than is the case with actively managed funds. Bid-offer spreads are tight, brokerage costs low, and there are none of the hidden charges often associated with other funds. The internal administration costs will be competitive, particularly for the larger ETFs, and total expense ratios (TER) for ETFs undercut those of other collectives.portfolio positioningAs the range of available funds has expanded so has their use in portfolio construction. For the retail investor, ETFs can provide a neutralised central portfolio to which higher risk investments can be added. This core-satellite construction uses the well-diversified index tracker to which higher beta investments, such as actively managed funds or direct equity investments, are anchored. Representing all the stocks in a given index, the ETF provides greater diversification for the core portfolio than could realistically be achieved through direct investment and does so more cost-effectively than would be the case using other collective investments.For fund managers, the deep liquidity of some ETFs provides a quick and cost-effective route to repositioning a portfolio. Where there is an expectation that the equity market will move ahead, the purchase of an ETF, which can convert cash to shares more quickly than could be achieved by dealing in a range of direct equities or actively managed funds, enables the fund manager to take advantage of short-term opportunities when they arise. Having gained this instant exposure to the equity market, the fund manager can switch from an ETF to more actively managed investments when appropriate, all the while maintaining exposure to the underlying equity market should a longer-term position be taken.ETFs can also assist the fund manager in more subtle strategic positioning of portfolios, again avoiding the costs of using other collectives and in particular the bid-offer spread of open-ended funds. For example, there are ETFs that cover each of the market capitalisation ranges, permitting fund managers to favour large, medium or small-cap stocks within a portfolio without relying on a specialist active fund. It is also possible to inject a style bias into a portfolio using ETFs, whether it be growth or value, again without the reliance on a specialist active fund. And the sale of an active fund and the reinvestment in an ETF covering the same market will allow the fund manager to neutralise the specific risk within that element of a portfolio, while maintaining exposure to that market.share abilityLike open-ended funds, but unlike investment trusts, shares can be created and redeemed as demand dictates. To create additional ETF shares, an authorised participant assembles an appropriate basket of stocks that it delivers to the custodian bank in return for a block of shares in the ETF. These shares can then be traded on the secondary market. Conversely, the return of ETF shares to the custodian bank in exchange for a basket of the underlying stocks results in ETF shares being redeemed.The ability to create and redeem shares allows for efficient pricing. With a fixed number of shares in issue, an investment trust may trade at a premium or discount to the value of its underlying assets where supply and demand for the share are in balance. With an elastic supply of shares, an ETF will price close to the exact value of the underlying stocks. In light of the simple mechanism for creating and redeeming shares, any premium or discount would represent an arbitrage opportunity and could expect to be short-lived.The liquidity of an ETF equals that of the underlying stocks in the index it is positioned to track. The more liquid the stocks, the more liquid the ETF. The major ETFs mirror the major indices, which more often than not have the most liquid stocks as their constituents. This allows for large blocks of ETF shares to be created, providing fund managers with sufficiently deep liquidity to take large positions quickly.Like shares in investment trusts, but unlike units in open-ended funds, ETF shares are priced and dealt throughout stock exchange trading hours. UK ETFs at the London Stock Exchange trade on the stock exchange trading system (Sets) and settle in Crest, and have bid-ask spreads that will generally reflect those of the stocks in the underlying indices. Open-ended funds price once daily and bid and offer prices for that day's dealing will be based on that price. ETF shares can be bought and sold inexpensively through any stockbroker.all-day tradingThe ability to deal all day allows the ETF investor to lock in a price for the underlying stocks at the time they wish to trade. The investor is aware of the prevailing price in the market at the time the trade is placed and can ascertain the execution price as soon as the transaction is completed. There is no need to wait until the next dealing point, as would be the case with an open-ended fund. In multi-manager products, ETFs have been used to gain exposure to efficient markets, where active fund managers have struggled to outperform the indices. A good example is the US equity market, where managers have found it difficult to exceed returns generated by the S&P 500 index and the ETFs permit cost-effective exposure. Multi-managers have also used ETFs to take advantage of short-term investment opportunities, given their low cost, deep liquidity and the ability to invest throughout the trading day.At times these short-term moves have developed into longer-term investment decisions but with asset allocations having been appropriately positioned, at times no additional investment has been required.
ETFs can provide a neutralised core portfolio to which higher risk investments can be addedManagement charges and tracking errors give rise to modest deviation from index returnsETFs are extremely liquid if investors want to convert to cash
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