Beware of ETF doppelgängers
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Senior Writer
Jody Clarke Jun 16, 2008
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Once, exchange-traded funds were the preserve of institutional investors. Now, anyone can buy in. But tread carefully, says Jody Clarke: some ETFs are more equal than others
It’s hard to believe that only eight years have passed since the launch here in Britain of the first exchange-traded funds (ETFs). But where investors were once restricted to buying a small range of major index trackers, they can now choose from more than 330 ETFs listed on the London Stock Exchange alone, tracking everything from water stocks to soft commodities, to the stockmarkets of the Bric economies (Brazil, Russia, India and China) and Taiwan.
Of course, the greater variety of ETFs available also makes it harder to choose which to go for. Back in 2000, for example, there was just one ETF tracking the FTSE 100 index. Now there are at least four listed on Trustnet. And as you move into more exotic areas, such as emerging markets, ETFs that on the surface look as though they should be closely related, may actually be tracking very different underlying indices. So how do they vary from each other, and how can you choose between them?
Mind the gap between similar ETF products
Although two ETFs might look like they do the same thing, they often go about it in a different way, which results in differences in performance. For example, the Lyxor FTSE 100 (LSE:L100) and iShares FTSE 100 (LSE:ISF) ETFs both track the top 100 UK stocks. However, their performance has been anything but identical. The Lyxor ETF has a long-term tracking error of –0.02% against 0.47% for the iShares ETF, making the Lyxor product a far more accurate follower of the index.
The reason behind the gap lies in the way each ETF attempts to track the FTSE 100. Barclays takes a ‘full replication’ approach, which means it holds every stock in the FTSE 100 and so incurs dealing costs and tax charges. Lyxor (and Deutsche Bank’s db-x tracker FTSE 100 ETF), on the other hand, uses ‘synthetic replication’. This involves utilising a derivative called an index swap, whereby an investment bank will agree to give the ETF provider the return on the index in exchange for a fee. This “effectively eliminates all sources of tracking error except the management fee, which is a known”, Manooj Mistry, a director at Deutsche Bank, tells Citywire.
ETFs: look under the bonnet
The differences between the FTSE 100 trackers may not seem important enough to fret about. But when it comes to the more exotic ETFs, it’s vital to take a look under the bonnet to see which markets they are actually tracking. Take the three Bric ETFs on the market. Sure, they all offer access to the Brics economies, but depending on which one you buy, you will get a very different level of exposure to each market.
For example, should you buy the Claymore/BNY BRIC ETF (AMEX:EEB), you would get a 5% exposure to the Russian market, against 30% and 29% for the iShares MSCI BRIC Index Fund (NYSE:BKF) and the SPDR S&P BRIC 40 ETF (NYSE:BIK) respectively. So, examine a fund’s prospectus carefully before you invest.
Stay clear of small, illiquid ETFs
Another point to remember when buying an ETF, says Richard Widows on Thestreet.com, is that you should aim for the one with the biggest market cap. Because ETFs trade on the open market, there’s the potential for them to trade above or below the underlying valueof their shares, just like an investment trust. Now this would defeat the point of an ETF, so to stop this happening, “qualified participants” – usually large brokers – use arbitrage to keep the ETF in line with its net asset value (NAV).
Broadly speaking, if the ETF is trading above its NAV, the arbitrageur will build a portfolio that matches the underlying stocks in the ETF, and swap it for the equivalent ETF shares, which it can then sell on for a profit. The opposite happens when the ETF trades above its NAV.
So far, so good. However, says Widows, for arbitrage to work smoothly, there has to be a decent level of liquidity in the ETF. The arbitrage typically involves “blocks of 50,000 to 200,000 shares”. This can be a real issue with ETFs as ever more launches have come onto the market.
For example, in the first two months of this year, Widows found that the top 10% of US ETFs (67 in total) accounted for 95.1% of stock turnover in the sector. At the other end of the range, 18 ETFs averaged less than 500 share trades a day, “a fraction of the turnover required for... arbitrage operations needed to keep prices and NAVs in close alignment”. So stick to the “big, heavily traded funds”.
Most important: check the ETF charges
Fees have a major impact on long-term returns and are probably the most important factor in choosing an ETF. According to Morningstar, the iShares FTSE100 ETF, which has a total expense ratio of 0.4%, has returned an annualised 10.59% over the past five years against 9.5% for the UBS-ETF FTSE 100, with a total expense ratio (TER) of 0.6%. If you’re looking for an even cheaper FTSE 100 ETF, both the Lyxor fund and db-xtracker FTSE 100 ETF (LSE:UKX) have TERs of 0.3%.
Also bear in mind that while ETF charges are about half those levied by traditional funds, they are bought and sold on the stockmarket, so you will incur dealing fees. The reality is that unless you are trading very small amounts on a regular basis, the saving you make using an ETF rather than a unit trust is likely to outstrip the dealing costs, but it’s something to be aware of.
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