Why you should buy into ETFs

By Editorial staff Simon Wilson Feb 17, 2006

The traditional fund management industry has had its day. Exchange traded funds (ETFs), a new form of index-tracking investment fund, are set to come into their own. History is packed with examples of good ideas that outlived their usefulness. Consider the homing pigeon, the horse and cart, and the hour glass, for starters. All were relegated to the scrap heap of history in favour of better, more efficient forms of technology. And this, according to Doug Fabian, writing in Johan Maudlin’s Weekly E-Letter, is exactly what is about to happen to the traditional fund-management industry. The reason is simple. Something better has come along. That something is exchange traded funds, “an idea whose time has come”. Why? Because ETFs offer two things that will never go out of fashion: “simplification and savings”.

How they work

An ETF is essentially an index-tracking investment fund. Like an index-tracker unit trust (and similar vehicles, such as Oeics), ETFs offer investors a handy way of owning a very diversified range of assets within a single wrapper. When you buy an ETF, you acquire a part of a fund that owns certain securities, rather than the underlying assets themselves – just as you do with a unit trust. So far, so much like a traditional mutual fund. The difference is that an ETF is bought and sold like a share – with the price moving continuously through the day. In contrast, units in unit trusts can only be traded once a day at a fixed price related to a closing net asset value. That makes ETFs not just a very simple way to invest, but also a far more flexible and efficient tool than traditional funds. Not only can you buy and sell at any time you want, but you can place order limits at specific price levels, or even ‘short’ your chosen index. ETFs are also exceptionally transparent: when you buy, you know exactly what shares are held inside the ETF, and those components don’t change.

Why they’re cheap

One reason that ETFs should gain in popularity fast is that they really do make savings, and this is of vital importance today. Most funds charge 1% to 2% a year in management fees (the actively managed ones are at the high end here), but the average ETF charges a mere 0.5%. That 1% difference may have meant little during the long bull market (if your fund was up 18%, what difference did a 2% fee make?). Today, however, with markets in the doldrums, it means a lot. And what’s more, even though ETFs are traded like shares, they are not liable for stamp duty, and that has the beneficial effect of keeping down transaction costs.

The ETFs you can buy

In 1993, says Morgan Stanley’s Deborah Fuhr, there were just three ETFs in existence, with $811m in assets under management. By contrast, as of June 2004 there were 304 ETFs available worldwide, with total assets of $246bn managed by 35 different fund management firms and listed on 28 stock exchanges. In Britain, the sole current provider of ETFs is Barclays Global Investors (BGI), the largestETF manager in the world, with 2,600 institutional clients in 47 countries, and around $95bn under management. BGI has increased its share of the global ETF market over the past four years, and now has a $6.5bn chunk of the fast-growing $25bn European market. Europe’s biggest supplier is Indexchange with $7bn under management, a 28% share.

The most popular ETF in the UK is the iFTSE 100, which tracks the FTSE 100 index. There are also UK-listed ETFs that track US, European, and corporate bond indexes. But through stockbrokers, UK investors also have access to all kinds of ETFs covering different sectors and markets. In particular, there are a plethora of US-based ETFs made available by BGI, Lipper, Vanguard, Merrill Lynch and others, covering everything from the Nasdaq and other national indices, to Japan, Canada and individual sectors. Later this year State Street, a US bank, will help launch China’s first ETF, based on the Shanghai 50 Index.

Do it with bonds, too

In the UK, the first three corporate bond ETFs were launched this spring (see box bottom left). According to Mark Roberts, head of iShares product strategy for ETF-provider Barclays Global Investors, this is an area that is ripe for development, and which is likely to see several new product launches in the near future. “Being able to buy a single share offering a diversified exposure to corporate bonds fills a crucial niche”, says Roberts, writing in Investment Adviser. Worries over liquidity and transparency have sometimes put off potential investors in corporate debt; both these concerns are tackled by a simple investment in an ETF.

Who’s buying them?

Within five years, ETFs could be a routine purchase for investors, just as unit or investment trusts are today. That’s the main finding of an extensive survey published by investment bank Morgan Stanley last month on the explosion in popularity of ETFs worldwide over the last few years.  So far, they have remained relatively little known among retail investors in Britain (perhaps in part because they trade as shares, so there is no commission payable to financial advisers who recommend them, and hence little incentive for them to do so). This makes the main buyers of ETFs still institutional investors, who use them as part of broad risk management, cash management and asset-allocation strategies, attracted by a combination of transparency, convenience and flexibility. Some big investors use ETFs as a main portfolio holding because they offer a high level of diversification that would otherwise be time consuming and expensive to arrange.

Why you should buy them too

You get everything you would get from a traditional fund with an ETF, but virtually none of the down sides, says Doug Fabian. The fees are lower, there are no trading restrictions and you get instant trade execution and objective management tied to the market itself (for the most part ETFs are tied to established indices). Yet you get the same level of diversification. ETFs are a “powerful idea” that might just make the traditional fund obsolete.

 

Published in How to invest | More articles by Simon Wilson

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