All a bit of fund – Exchange Traded Funds

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Are you an investor? Have you heard about Exchange Traded Funds (ETFs)? Here’s your chance to learn more. as they may be just what you’re looking for.

ETF is not another one of those City-created, product acronyms that people interested in investing can or should ignore. It is the abbreviation for a relatively new investment product called an Exchange Traded Fund. It is changing the way novice and experienced investors think about portfolios, diversification and asset allocation.
The ETF was created by the American Stock Exchange in the mid-1980s and is now available in Britain. It is an investment instrument which trades on a stock exchange, exactly like a company’s ordinary shares, while offering some of the advantages of a traditional tracker fund, such as diversification and low costs. In short, it looks like a unit trust, but trades like an ordinary share.

"This sounds too good to be true," I said to myself when I first read about this product. "It must be horribly complex in order to combine these features! There must be something I’m missing!" To add to my scepticism, its name kept changing. First it was called an Index Participation Unit (IPU), then an Index Share until, finally, the marketplace settled on Exchange Traded Fund (ETF) – even if, in the share-listing pages of The Wall Street Journal, it is an Exchange Traded Portfolio.

Since ETFs were introduced, however, I have come to believe that they are an investment product which every investor, from the beginner to the experienced, must understand and consider as a part of their investment strategy. My change of mind was prompted by two friends, John Keefe in Chicago and Stanley Stefanski in New York. Each told me on separate occasions that he was going to make ETFs the core of his investment holdings and strategies. These friends have very different financial means and different levels of experience in the financial market. Although both lost some money when the Internet bubble burst in 2000, they have little else in common as investors. Even their investment strategies are different: John, who was once a broker, is a conservative, value-orientated investor while Stan focuses on capital growth, occasionally doing some intraday (‘in and out’ in a day) trading. I interviewed them separately for this article and have included in their own words some of the wisdom each has gained using ETFs as an investment vehicle.

These two friends decided independently to use ETFs as part of their overall investment strategies, and that’s what made me take notice. Not only did I decide to find out more about ETFs, I also wanted to see if they were appropriate to my own investment objectives which were somewhere between John’s conservative, value orientation and Stan’s somewhat aggressive growth objective.

Before making any investment, I always believe you need to understand: the product itself; its rewards and risks; and the cost associated with buying, holding, and selling it. This is especially true for ETFs, whose simplicity and features can make investors think they have found the Holy Grail of investments. Keep in mind as you read this article that it is good – but not perfect.

What is an Exchange Traded Fund?
Strictly speaking, an ETF is not a fund: it is an ordinary share, traded on a stock exchange. But it acts like a fund because it invests in the shares of other companies, typically the shares of the individual organisations which make up a specific index, such as the FTSE 100, the NASDAQ 100, or the Dow Jones Industrial Average.

More recently, sector-specific ETFs have been created. For example, rather than a general index such as those listed above, the ETF will invest in oil and gas companies, technology firms, or pharmaceuticals manufacturers.

If you think this sounds just like a unit trust (especially a tracker fund), you are well on the way to understanding an ETF. The key difference between a unit trust and an ETF, however, lies in one of the most misunderstood features of a traditional unit trust. A unit trust is not a tradeable security, as many people believe. There is no secondary trading market (such as a centralised exchange or electronic stock market) that enables you freely to buy unit trust shares from or sell them to other individual investors through their brokers.

More accurately, a unit trust is a redeemable security. That means investors purchase and redeem shares of the unit trust either directly with the investment company that created the trust, or through an intermediary such as an IFA or stockbroker. It is the investment company that then buys or sells the stocks of individual companies which make up the fund. Thus it is the investment company that interacts with the stock market, not the individual. As shares within the unit trust are bought and sold, turnover increases, creating potential tax consequences and generating transaction expenses – all potential negatives for investors.

Also, orders to buy or redeem unit trusts are executed only at the end of the business day on which your redemption order is received by the investment company. This occurs after the stock exchange’s daily trading session ends and the closing prices of the individual companies’ shares in the portfolio have been determined. As a result, the price at which you buy or redeem a unit trust is based on the closing market value of the ordinary shares in the underlying portfolio.

Imagine the following scenario. You hear around noon that the FTSE is declining steeply. You want to sell your tracker fund before the index goes any lower. You place an order shortly after noon to sell (redeem) some or all of your unit trust holdings. Your order will not be executed until the end of the business day, by which time the FTSE could have gone even lower. You are frustrated. The recognition that there are investors who want a tracker fund-like product which they can trade at any point during the trading day, rather than waiting for an execution only at the end of the day, led to the creation of ETFs.

How is an ETF created?
Keep in mind that there are two components to an ETF: the underlying portfolio of companies’ ordinary shares that constitute the index; and the actual ETF shares that trade on the stock exchange.

Let’s explain the underlying portfolio first. It is created and managed by an investment company known as a product provider. In the UK, Barclays Global Investor (BGI) and Merrill Lynch are the two ETF product providers.

Importantly, the product provider decides what fractional amount of the underlying index each ETF will represent. Some ETFs represent a tenth of the value of the specific index. If, for example, the FTSE All Share Index closed at 1835.10, an ETF based on this index would have a value of 18.35. Other funds could represent 1/20th or 1/100th of the index; the fraction is decided when the product is created. So, in reality, each ETF you buy represents a fractional participation in the performance of the index. As the companies’ stocks which make up the index changes, so will the price of the EFT based on that index. Technology enables the market to calculate this value in real time, trade by trade.

The product providers then work with other large financial institutions, such as Morgan Stanley, or Goldman Sachs, to make ETFs available to investors. The financial institutions in this second group are known as authorised participants. The role is to create the actual ETF shares. Usually with company shares, an initial public offering (IPO) creates the supply of shares that trade in the market. With ETFs, however the process is considerably different. ETF shares are only created in large blocks of, say 10,000 or 50,000 shares or multiples thereof. These are called creation units, and the product provider sets the minimum number. However, it is the authorised participants who create the creation units.

How do they do that?
Now things start to become complicated. They must transfer to the product provider (who maintains the underlying portfolio) a basket of the shares that make up the index, plus a designated cash component equal to the accumulated dividends on the individual company shares. The market value of the basket must be sufficient to create the minimum number of creation units (the actual ETFs) or multiples thereof at their current market value. As the demand for the ETFs rise, the authorised participants will deliver the required baskets of company shares to create more creation units. If there is too much supply, the authorised participants can buy back a block of ETFs and return them to the product provider in exchange for the basket of stocks originally used to create it.

In simple terms, the authorised participants turn baskets of shares (from the companies which make up the index) turned into blocks of ETF shares that can then be traded freely on the secondary market – through a stockbroker – by individual investors like you and me! Authorised participants also have the ability to redeem ETF shares. As you would expect, this can be done only in the minimum number of creation units or its multiples. When a market participant buys back the fixed number of ETFs in the open market and returns the block to the product provider, the basket of shares plus the current cash component originally used to create the ETFs are returned.

This creation/redemption process by the market participants tends to minimise the annual operating expenses associated with ETFs because it reduces the transactions cost related to purchasing and selling the shares in the open market. It also means that the number of ETFs available in the secondary market can increase or decrease in response to market demand with relative ease and, again, at low costs. A comparison of the annual fees illustrates one of the cost differences. Compared with a traditional unit trust, ETF annual fees can range from being approximately 14 per cent lower than an unmanaged unit trust (such as a tracker fund) to around 70 per cent lower than some managed unit trusts. A typical management fee for ETFs in the UK ranges from 0.35 per cent to 0.5 per cent. This difference means one thing to the individual investor: more of the profits end up in their pockets.

An ETF share also provides the same dividend yield as the index it is tracking (after expenses). As the companies in the underlying portfolio – whichever companies make up the index – pay dividends, the cash is held by a custodian bank that then pays the money to the shareholders annually, biannually or quarterly. The frequency differs among ETFs, and is set when the shares are created.

What are the primary advantages of ETFs?
Warren Buffett, known as The Oracle of Omaha, is arguably the world’s greatest stock market investor, worth about $36billion or thereabouts. Words of his spring to mind now: "Diversification serves as protection against ignorance. If you want to make sure that nothing bad happens to you, relative to the market, you should own everything."

If you are buying individual stocks, achieving diversification can be expensive. The low costs associated with buying and holding ETFs makes them a very attractive way to achieve diversification instantly. "Rumours of questionable accounting practices or of an investigation by a regulatory authority can cause the price of a stock to drop 50 per cent in one day. While an index containing that stock might also drop, it won’t decline by anywhere near the same percentage," says Stan, one of my two friends who have taken the ETF route.

Both he and John also cite a widely known statistic in answer to the questions: more than 80 per cent of managed funds under perform the market as measured by a benchmark index, such as the one of the FTSE indices in the UK or the Standard & Poor’s 500 in the US. "When I was growing up, I would always strive to be above average," John says. "However, in investments, average can be very good."

John cites another advantage of ETFs he has experienced. "There is no portfolio drift with an ETF. Near the end of each year, I read the upcoming year’s forecast to see what sectors money managers are looking at for growth. I am not concerned with individual stocks; instead, I focus on sectors. Two years ago many experts felt that mid-cap value stocks would do well. So I went and took a look at the best performing managed funds in this category. One fund jumped out of the group. It had routinely exceeded the performance of the mid-cap value index for each of the one, three and five-year periods reported. Thinking I had found my investment, I looked no further. That proved to be a major mistake. The reason for the fund’s superior performance was the portfolio was almost exclusively made up of telecom and tech stocks, which were on fire during the time periods reported. In reality, the fund was more of a telecom/tech fund than a mid-cap value fund. By the end of the year, the fund had woefully underperformed the index, since the telecom/tech bubble was bursting. The mid-cap value index went up that year, while my fund tanked. In the end, there was a 30 per cent difference between the performances of the two funds. The portfolio drift costs me. What made it even more frustrating was I picked the right sector, but fell victim to portfolio drift. There is no portfolio drift with an ETF." "And let’s not forget the dividends that are paid out periodically," Stan adds. Like most ETF investors, Stan reinvests the dividends he receives in the same ETF.

Is asset allocation more easy or difficult with ETFs?
John and Stan take different approaches to investment. John addresses the concerns of the conservative investor, regardless of their experience in the market and says: "ETFs make assets allocation and reallocation a lot cleaner and easier because you don’t have to deal with a portfolio of 20 or more stocks. Therefore, as a core holding, ETFs are perfect. If, for example, you have an ETF as your core holding with 60 per cent of your serious money invested in a diversified large-cap index, then you can use sector ETFs to take advantage of lows in specific industries. And you still get the intellectual challenges of selecting these lows in the sectors that interest you. Can you imagine trying to achieve this type of blend with individual stocks?"

Stanley agrees that establishing asset allocation blends is easier with ETF, but adds a more trading-orientated perspective. "ETFs also give you the ability to switch within a day from growth orientation to value orientation in order to catch the mood of the public. Here’s an example. As soon as people’s expectations for the economy improve, growth-orientated stocks usually rise in price first. So I would buy an ETF whose underlying portfolio contains growth stocks. Then, when there is a drop in consumer sentiment, I’ll sell it and immediately short it. Another example is technology. When people are getting down on technology (which people are doing a lot lately), I’ll buy a technology ETF. If it is a large-cap play, I’ll buy and the sell the appropriate ETF. In the short term, I try to double the return that the market, as measured by the index, is providing. As a long-term investor, I try to beat the benchmark, by rotating among the various sectors using ETFs.

Are ETFs appropriate for a novice investor?
My friends agree that new investors should start out with an ETF which is based on a diversified index, such as the FTSE 100 or FTSE All Share. "If you own a small portfolio of individual stocks and have two or three really big losers due to accounting scandal or bad management, you can’t make any money," says Stan. Because an investor in ETF shares is already diversified, they can focus on becoming comfortable with the overall market, learning how various types of news affects it positively and negatively. In essence, a novice investor is starting with the overall picture, before moving on to specifics. As you grow more comfortable, you can move on to different types of ETFs such as big caps, small caps, or sector-specific options rather than stick individual companies where research and analysis is much more difficult and time-consuming. "No one can adequately follow that many stocks all the time, not even the best analysts," says Stan.

How can experienced investor use ETFs?
Stan reveals one of the biggest advantages of an ETF over a unit trust. "A sophisticated investor can sell short an ETF and profit as the market is declining. You can’t do that with a unit trust. If I see that the index has reached a peak and is about to begin dropping, I’ll sell it short. If I make a one per cent after-commission, after-tax, short-term profit on my investment, I buy in the short position. All of those one per cent profits eventually add up to a really good return."

"If you are sophisticated," John adds, "you can implement interesting strategies with ETFs. You can sell them short, write covered call options against them or use them to hedge your portfolio of individual stocks. These products can make your investing life easier and the enhance the overall performance of your portfolio."

What other advantages does an ETF provide?
"I think it helps the individual investor to avoid portfolio clutter," observes John. "When people invest in individual stocks, they tend to hold on to losers, always hoping that they will recover. Over time this can result in a rag-tag group of poor stocks that just sit uselessly in a person’s portfolio. It is more difficult for this to happen with an ETF because you are not buying single-company stocks. Hence, your portfolio and the money you have invested in the market stay neater and clearer."

Are there any problems with ETFs?
John and Stan cite virtually the same four concerns:

1. Sometimes the spread between the bid and the offer prices is a bit rich; sometimes it can be significantly different. This increases the cost of buying and selling the product, reducing your potential return.

2. ETFs tend to perform worse than managed funds in a bear market because they must always be fully invested in the market. Managed funds, on the other hand, can sit on the sidelines, holding on their investors’ cash until they feel the prices of individual stocks have reached a bottom or are attractively priced. "However," John cautions, "after you have done all of your research, there is no guarantee that you, an individual investor, can pick out a good managed fund in a down market."

3. Investors must be watchful of the proliferation of ETFs, especially those which contain 20 stocks or less. These are not really indices and may be over concentrated, exposing the investor to more sector-specific risk than he or she may be aware of. Investors need to know what individual company shares make up these types of indices before they use them as investment vehicles.

4. "Aside from these concerns," John says, "I think the only problems are those you make for yourself. By that I mean not knowing the composition of the index, thinking that ETFs are a product that can protect or guarantee you against losses and the usual – being greedy about your investment return."

Stan concludes: "Everyone says that the current market is a ‘stock picker’s’ market. I feel that, during uncertain times like these, you can quickly learn that stock-picking can burn you – sometimes badly. A better place to focus your investment attention is the overall market: how the major indices are likely to react to certain news. ETFs give you a way to profit from this overview."

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