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Exchange-traded funds (ETFs) are moving into the mainstream. According to the latest data from specialist consultant ETFGI, assets in the wider exchange-traded products (ETPs) space hit a new record of $2.99 trillion at the end of April – just short of the $3 trillion milestone.
The popularity of the low-cost tracking product means ETP flows can offer an indication of what the market is thinking.
Data from Markit shows that following two consecutive quarters of outflows from eurozone-exposed ETFs, the first three months of this year showed record quarterly inflows as sentiment towards the economic area improved amid the launch of quantitative easing by the European Central Bank.
Inflows of $19.3 billion were almost double the previous high of $11.4 billion set in the first quarter of 2008. To help garner some insights we take a look at a selection of the most heavily traded ETFs – using official figures from the London Stock Exchange. We also drill down into the individual products themselves to understand the exposures and underlying structures.
The tables from the LSE show the most traded ETPs in 2015 (up to the end of April) by turnover and number of trades. What they reveal is the continuing appetite for yield in a low interest rate environment. The top spot is occupied by iShares Euro High Yield Corporate Bond (IHYG).
This product uses physical replication to track the performance of the Markit iBoxx EUR Liquid High Yield index as closely as possible. This index comprises the largest and most liquid fixed and floating rate sub-investment grade corporate bonds issued by both eurozone and non-eurozone issuers. It distributes income on a semi-annual basis and offers a yield of 4.6%. The total expense ratio (TER) – which aims to offer a snapshot of the total cost of a fund to an investor – is 0.5%.
Physical vs. Synthetic
There are two main types of ETF: ‘physical’ and ‘synthetic’.
Physical, or cash-based, ETFs are those whose providers actually purchase and hold the assets or securities of the index they track. Should the provider go out of business, the investor has direct recourse to a ring-fenced pool of assets.
Synthetic, or swap-based, ETFs hold no underlying assets, but are financed by a counterparty, usually an investment bank, and vary in price more precisely equivalent to the return on their respective index, including capital gains and dividends. While a synthetic ETF can be much more accurate than the physical ETF in tracking, you are exposed to the risk of the counterparty hitting financial difficulty. To mitigate this many providers hold collateral against their products.
Number two on the list is iShares Core FTSE 100 (ISF). This is the UK’s first ETF having launched in 2000 and is consistently among the most popular ETFs listed in London as investors look to gain diversified exposure to the UK market. As a constituent of iShares’ ‘Core’ series – a range of nine of its most popular funds at ultra-low fees – it has a TER of 0.07%.
As a whole the leaderboard is dominated by products offering fixed income exposure. ETF industry participants have been consistently flagging this as an area of growth to Shares in recent years – partly because it is difficult for retail investors to achieve direct exposure to this asset class.
Commodities plays
Looking at the most popular by number of trades, it is interesting to note the presence of products tracking gold and crude oil. These products are officially known as exchange-traded commodities (ETCs).
ETF Securities’ ETFS WTI Crude Oil (CRUD) offers exposure to the West Texas Intermediate benchmark. Investors have clearly been keen to play a recovery in crude oil prices – up around 40% on their lows in January. The spread between WTI and the European benchmark Brent has narrowed from around $12 per barrel in February to the current $4 per barrel as the glut of unconventional supply in North America begins to ease.
The aforementioned ETC tracks the price of WTI through synthetic or swap-based replication although it is 100% backed by collateral in the form of shares and bonds.
With ETCs it is worth remembering the impact contango and backwardation can have on returns. Contango refers to the market condition whereby the price of a futures contract in a commodity is trading above the spot price. The resulting futures ‘curve’ would be upward-sloping with prices for dates further in the future trading at ever higher levels.
Backwardation describes the reverse – where futures are trading below the spot price – often because of short-term tightness in the underlying market. Arguably contango is a more natural state as it reflects costs of ownership such as storage and insurance.
What does this mean for the investor? When the product rolls contracts (sells them and buys new ones) in order to avoid taking delivery of the physical product, contango sees returns diminished and backwardation sees them enhanced.
From the same provider ETFS Daily Leveraged WTI Crude Oil (LOIL) is designed to reflect 200% of the daily percentage change in WTI crude oil futures contracts. If oil is rising you can in effect double your money but it is important to remember that the losses are also amplified from the market moving against you.
Gold bugs have clearly been attracted to ETFS Physical Gold (PHAU) which is quite rare for an ETC in that it invests directly in the underlying commodity. It is backed by actual gold bars – which are segregated, individually identified, allocated and held in trust by HSBC (HSBA).
Tech focus
Another notable constituent of the most traded by number of trades list is Source Technology S&P US Sector (XLKS). This offers a way to play the technology sector in the US – notably this is an industry which is under-represented on the London market.
Despite many high equity valuations, UK investors clearly haven’t fallen out of love with the US tech space yet.
Understanding the ETP universe
Exchange-traded funds (ETFs) are just one type of exchange-traded product (ETP), a generic term which covers three types of instrument.
Exchange-traded fund (ETF)
Under European rules, an ETF must hold at least five different securities or assets. They can be used to track the performance of a stock market index or bond index, for example, while themed ETFs which replicate the performance of a basket of stocks, bonds or commodities are also readily available. It is not possible to buy an ETF that tracks the gold or oil price, as this would mean the instrument owns just one asset.
Exchange-traded note (ETN)
ETNs trade on an exchange, just like an ETF, but they can be used to track just one underlying asset. An ETN is actually a debt instrument and it uses indirect replication to generate performance. The advantage of an ETN is it therefore eliminates any tracking error and can make it cheaper to invest in more esoteric or less liquid stock market indices. The risk comes with exposure to the ETN issuer. If it is a bank, for example, a downgrade of that institution’s credit rating could hit the price of the ETN even if the underlying asset does not move.
Exchange-traded commodity (ETC)
As its name suggests an ETC is a type of ETN designed to provide a means of accessing the underlying price trend provided by a single commodity, such as lean hogs, wheat, corn or cotton. Some ETCs use direct replication, notably in cases where storage is easy, such as gold or silver. Some use swaps to tackle liquidity or storage and insurance costs. Like ETNs, ETCs can be used to buy or sell exposure to commodities where the physical replication method is not practical owing to issues such as transport, storage and insurance costs and they tend to follow futures markets.
Tom Sieber Deputy Editor, Shares
Written by:
Tom Sieber
Tom Sieber is deputy editor at Shares and the magazine's resident oil and gas specialist. He started his career at the award-winning regional newspaper, The Chester Chronicle, and joined Shares more than six years ago - covering a number of sectors during that time including banking and insurance.
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