Consider the passive option

Writer,

Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

For this week’s edition this column is indebted to the London Stock Exchange for pointing out that the UK’s first Exchange-Traded Fund (ETF) has just celebrated its fifteenth anniversary. iShares FTSE 100, which comes with the ticker ISF, began trading in London in late April 2000. The instrument now has £3.8 billion of assets under management and is one of 791 ETFs which trade on the London Stock Exchange, where total turnover in ETFs rocketed from £3.9 billion in 2004 to £185 billion in 2014.

In the first quarter of 2015, iShares FTSE 100 was the second most actively traded ETF by value on the London Stock Exchange by turnover and the leading instrument when measured in terms of individual trades. Its longevity and size are testimony to the many characteristics of ETFs for clients, notably liquidity and also low costs – the iShares FTSE 100 ETF comes with a total expense ratio (TER) of just 0.07% per annum. Clients do not have to pay stamp duty on their actual purchases of ETFs but other charges are potentially involved, including stamp duty on their share dealings as they follow and mirror the performance of the underlying index or basket of securities. Even so, this looks every bit as competitive as well-established tracker or index funds. These are Open Ended Investment Companies (now also known as Investment Companies with Variable Capital) or Unit Trusts and are also worthy of consideration for those clients who wish to keep their market exposure broad and cost effective. Clients do not have to pay stamp duty on their actual purchases of OEICs either, even if the funds will again be paying the levy on their own equity market transactions.

For all of their development over the past 15 years ETFs are still a relatively new phenomenon for many clients and their advisers and this column is delighted to say it will be participating in ETF.com’s sixth annual Inside ETFs Europe conference in Amsterdam on 8-10 June this year to help delegates better understand this market. Details can be found here: http://europe.etf.com/inside-etfs-europe-conference/.

Mirror, mirror

Exchange-traded products (ETPs) offer flexible and transparent exposure to a variety of different asset classes and markets. They mirror, or track, the performance of an index, basket of stocks or certain asset class and as such can be used by both long-term, ‘buy-and-hold’ investors and short-term traders to execute any number of different strategies.

The tables below provide examples of some of the themes which clients can address using ETFs. They show the 10 most actively traded ETFs on the London Stock Exchange in the first quarter of this year, as measured by volume and value.

The 10 most heavily traded ETFs in London in 2015 to date by volumes

ETF EPIC Turnover (£ million) % Total
1 iShares Euro High Yield Corporate Bond UCITS ETF IHYG 3,498 5.0%
2 iShares Core FTSE 100 UCITS ETF ISF 3,201 4.6%
3 Vanguard S&P 500 UCITS ETF VUSD 2,167 3.1%
4 iShares JP Morgan Emerging Market Bond UCITS ETF IEMB 1,780 2.5%
5 iShares $ Corporate Bond UCITS ETF LQDE 1,494 2.1%
6 iShares $ High Yield Corporate Bond UCITS ETF IHYU 1,352 1.9%
7 Vanguard FTSE 100 UCITS ETF VUKE 1,321 1.9%
8 iShares Core S&P 500 UCITS ETF CSPX 1,146 1.6%
9 ETFS Physical Gold PHAU 1,144 1.6%
10 iShares S&P 500 UCITS ETF (Dist) IUSA 1,075 1.5%

Source: London Stock Exchange, January to March 2015

The 10 most heavily traded ETFs in London in 2015 by value

ETF EPIC Trades % Total
1 iShares Core FTSE 100 UCITS ETF ISF 110,387 12.7%
2 iShares S&P 500 UCITS ETF (Dist) IUSA 52,474 6.0%
3 ETFS Physical Gold PHAU 17,193 2.0%
4 ETFS WTI Crude Oil CRUD 13,909 1.6%
5 Vanguard FTSE 100 UCITS ETF VUKE 12,890 1.5%
6 Gold Bullion Securities GBS 12,753 1.5%
7 SPDR S&P US Dividend Aristocrats UDVD 12,319 1.4%
8 Vanguard S&P 500 UCITS ETF VUSD 12,270 1.4%
9 Source Technology S&P US Sector UCITS ETF XLKS 9,869 1.1%
10 ETFS Daily Leveraged WTI Crude Oil LOIL 9,762 1.1%

Source: London Stock Exchange, January to March 2015

The mechanics

ETFs tend to use one of two main mechanisms to track and deliver the performance of the underlying assets. In simple terms, one uses derivatives and one does not and this may help shape clients’ preference for which instruments they prefer to use.

  • Physical replication, whereby the ETF directly owns the underlying basket of stocks or securities, or at least to a degree as makes no difference. This should deliver accurate performance but can incur additional frictional costs as and when an equity index's constituents change, for example, as the ETF will have to sell the ejected stocks and buy the inserted ones each quarter
  • Synthetic replication, where the ETF use derivatives contracts offered by brokers and investment banks to generate the performance offered by the index or stocks it is tracking. Synthetic products can be especially useful where gaining direct access is difficult, such as emerging stock markets, when storage is an issue, as with say agricultural crops, or where the client does not wish to run the risk of having to take physical. Synthetic tools also eliminate tracking difference, the amount by which an ETF’s returns deviate from its benchmark index, as they are not exposed to the inefficiencies of the physical market.

Detractors of synthetic products argue they exposed to counterparty risks and can become illiquid in the event the firm on the other side of the transaction gets into financial difficulties.

Synthetic providers counter by highlighting the high levels of disclosure they provide. The collateral used to back the product is outlined in detail on their websites and the idea is these assets can be sold in the unlikely event of any problems, to ensure the ETF holder gets their money back.

ETFs versus index funds

Fans of ETFs argue they offer liquidity since they can be bought at any time of day on an exchange, just like any stock. Supporters also wax lyrical about their flexibility, as they can be used to open new exposures or hedge existing ones for clients, through 'short' ETFs, and their transparency, as their holdings are disclosed daily, in contrast to actively managed funds, which tend to give monthly updates.

Innovation is also high up the list of features which appeal to some clients. In March, 12 new ETFs were listed in London, including products which offer dollar-hedged exposure to Japan’s Nikkei 400 index and UK real estate.

The chart below shows the number of ETFs listed in London annually since 2004. Note these numbers exclude other Exchange-Traded Products, namely Exchange-Traded Commodities (ETCs) and Exchange-Traded Notes (ETNs) of which there are some 366 available to trade in London.

ETF issues on the London Stock Exchange by year

ETF issues on the London Stock Exchange by year

Source: London Stock Exchange, April 2015

Cost is also high up on the list of advantages cited by users of ETFs, although this could also apply to some of the big, classic tracker or index funds. Vanguard’s FTSE UK All Share Index unit trust comes with a TER of just 0.08% per annum and the US fund giant’s latest piece of research highlights how this can make a difference. While clients must accept Vanguard’s entrenched position as a leading provider of index, or tracker, funds, the numbers do look compelling (and it must be noted Vanguard is a huge provider of ETFs, too). Its data show how costs can impact the total performance delivered to a client by a fund. The analysis covers 2004 to 2014 and asserts that when funds are split into lower-cost and higher-cost quartiles the low-cost ones outperformed in 10 of 11 categories, by between 0.2% and 2.6% a year. That might not sound a lot, but 2.6% compounded over 10 years adds up to an extra 29% on a client’s returns. Quite why European Equity is the exception to the rule is a matter for debate and it would be interesting to see how the performance numbers for ETFs with sufficient longevity would stack up.

Vanguard research makes a case for passive investment and tracker funds

Vanguard research makes a case for passive investment and tracker funds

Source: Vanguard Investment Management. Shows the annual difference in performance between the median low-cost and high-cost quartile active and passive funds.

Some clients may prefer index trackers, others ETFs. Some of the key issues to watch are

  • How performance is delivered. Trackers will own the assets whereas, as already noted, some ETFs may use derivatives rather than ownership of the underlying to generate performance.
  • Liquidity.Trackers are OIECs (or ICVCs) or Unit Trusts and clients therefore tend to be able to trade once a day. ETFs are freely available to trade on an exchange like a stock, although it would perhaps be unwise to expect any ETF to be more liquid than the underlying assets it tracks.
  • Pricing. The price of an ETF will be set by the market and the client should have a fair idea of what it is before they get involved.
  • The bid/offer spread. Since they are quoted like a stock, ETFs come with a bid/offer spread, which can vary according to its liquidity and also how easy it is to buy and sell the underlying assets. The amount of assets under management and the number of active market makers in an ETF will help advisers and clients judge how liquid it can be, relative to rival offerings. Unit Trusts also come with a bid/offer spread and although OEICs do not, this cost is usually buried away within other fees related to the fund.
  • Tax. Client purchase of ETFs and OEICs are free of 0.5% stamp duty, although the instruments’ dealings in the underlying securities to make sure they track a benchmark as accurately as possible will be.
  • Other costs. A big issue here is the total expense ratio (TER) which can vary a lot although both are generally competitive. How a broker or platform charges for dealing in and holding these instruments should also be investigated carefully.

Active angle

Vanguard’s data looks powerful when it comes to arguing the case for so-called ‘passive’ funds, trackers or ETFs, but this is not to deny the service a good ‘active’ fund manager can provide, either via an OEIC or Investment Trust. They should deliver outperformance to justify their fees, and passives will never really outperform – they are not designed to do so by their very nature. A good fund manager with a strong long-term track record can and will attract client support, as the hefty demand for Neil Woodford’s Patient Capital investment trust shows all too well. Such luminaries are relatively few and far between and they do more than pay their way when you can find them, although advisers without the time or inclination to do the necessary research may find that trackers and ETFs can still help point portfolios in the right direction, once the donkey work of asset allocation has been done.

Russ Mould, Investment Director, AJ Bell


russmould's picture
Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.


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