Edward O’Hanlon, Pensions and Investment Advisor at Acuvest, examines the prominence of Exchange Traded Funds (ETFs), and their place in the investment world.
ETFs have seen record inflows in the last four years, which has prompted many asset managers to launch products. In December, the Financial Times found that over 800 new ETFs were launched in 2017, bringing the number for sale globally to over 7,000.
To understand their popularity (and utility), we must first understand the product and its place in the world of investments.
What is an ETF?
An ETF is an investment vehicle, like a unitised or mutual fund, that is traded on a stock exchange the same as shares in a publicly quoted company, that can contain a diversified collection of assets (e.g. a representation of all of the shares that make up a particular stock exchange index).The first ETF was introduced in 1993 and since then investing in ETFs has grown to be a $4.5 trillion industry.
How ETFs work:
There are two different kinds of ETFs, Physical ETFs and Synthetic ETFs.
Physical ETFs attempt to track their target indexes by holding all, or a representative sample, of the underlying securities that make up the index. The majority of ETFs that are brought to the market in Europe today are physical ETFs established as UCITS unitised funds.
The term UCITS is an acronym of Undertaking for Collective Investment in Transferable Securities, which is used to describe a form of unitised funds that is commonly used and regulated in a harmonized fashion across the European Union. In the case of UCITS funds, all investors are issued with the number of shares in the fund that represents the value of their investment comprised of their share of the investments of the vehicle.
The advantage of establishing an ETF as a UCITS is that it benefits from a brand that is recognised and understood throughout the world. There are restrictions on the investment and borrowing policies of UCITS and on the use by UCITS of leverage and financial derivative instruments which are designed to protect investors and prevent excessive risk taking.
By contrast, a synthetic ETF does not directly invest in the index’s constituents. Instead, the synthetic ETF provider enters into a contractual agreement with an investment bank, with the latter promising to pay the ETF provider the daily return from the index being tracked, plus any dividends due, in return for a fee.
The case for investing in Synthetic ETFs, many of which are not UCITS approved, is far less persuasive. Synthetic ETFs may use swaps and derivative instruments which are exposed to counterparty risk. Counterparty risk is the risk that the issuer of the derivative defaults or fails to honour their contractual commitments.
Why are Institutions investing in ETFs?
The earliest ETF adopters in the institutional channel—primarily in North America—started employing the funds to achieve short-term, tactical positions within equity portfolios, in a manner that was easier, quicker, and therefore more efficient than buying or selling the range of underlying equities. Over time, their use has been extended to also include performing core strategic functions in a range of asset classes. Many institutions now view ETFs as both a means of obtaining strategic exposures and a valuable tactical tool.
Why are individuals investing in ETFs?
ETFs have some very attractive features for individual investors, the main one being diversification. Since the financial crisis individuals are acutely aware of the risks of owning just one investment, an Irish banking stock for example. Buying a share in an ETF gives individuals exposure to a number of different stocks or other investments. People have the option to spread their investment across a number of ETFs that track different asset classes such as equities and bonds and therefore further diversify their investment. The other features that make ETFs attractive for individuals are that they are often cheaper for retail investors than investing in mutual funds and they are also easy to buy and sell (from an investment firm or online brokerage any time when the stock exchange is open).
What you should know before investing in an ETF?
Since the first ETF was launched in Europe in 2000, increased regulation has unquestionably made ETF Investment a more attractive proposition for both individual and institutional investors.
From a fees perspective ETFs are undoubtedly a cheap way for individual investors to passively invest, however the case for large institutional investors is less obvious. While a small number of passive core ETFs are available for as little as 0.07% p.a., or 7bps (S&P 500 UCITS available for 7bps from both Blackrock and Vanguard), the average fee charged for core holding is closer to 20bps (0.20% p.a.) which is likely to be more expensive than what medium to large sized institutional investors are paying for similar sized investments through a passively managed mutual fund.
Before investing in an ETF you should carefully consider the objectives, risks and cost associated with the investment along with its potential role in your portfolio. This information can be found in the ETFs prospectus document. If you need help understanding the content contained in an ETF prospectus document, do seek Independent financial advice.
Edward O’Hanlon is Pensions and Investment Advisor at Acuvest. If you have any comments or wish to contact Edward, you can email him at EdwardOH@acuvest.ie
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