ETFs – how they work, how to use them, the costs and the risks.

3rd October 2013

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Exchange Traded Funds (ETFs) – a packaged investment alternative to OEICs, investment trusts which can also offer solutions to specific fund management situations – chalked up their twentieth anniversary this year. Investment journalist Tony Levene looks at the issue.

But what started as a simple alternative to S&P 500 tracker funds has become a trillion dollar industry with thousands of possibilities ranging from vanilla major index via agricultural machinery or precious metals to “who would have thought of it?” exotica such as the U.S. Equity High Volatility Put Write Index Fund (NYSEArca: HVPW) – see – Indexuniverse for more. The first rule of investing is never to put your money into anything you do not understand!

With the growing range come warnings. Because some ETFs depend on derivatives and can be geared (so both gains and losses are higher than in the underlying investment), they could malfunction. And if the riskier ones turn bad, this could undermine overall investor confidence. .

What are ETFs?

ETFs are created by financial companies such as Black Rock’s iShares, State Street and index fund specialist Vanguard. For most private investors, exchange traded funds are an alternative to other collective investments such as OEICs and investment trusts. They can be cheaper – but not always. They have some tax advantages such as freedom from UK stamp duty and can be included in an ISA. Like investment trusts, but unlike OEICs, they can be continuously traded. They are bought and sold like shares and bonds via a stockbroker.

Who uses them?

For private investors, they are a low cost method index fund, an alternative to an OEIC (or unit trust). They give instant availability to a sector which might be otherwise hard to access such as tobacco or pharmaceuticals or airlines. Larger funds use ETFs as to switch emphasis – a move from Asia Pacific dividend equities to eurozone smaller companies is difficult buying individual shares but is easy with ETFs.

Investors looking for niche investments in specific sectors such as agriculture, energy and precious metals may find ETFs are often the best option with around eight times as many to choose from with an average cost around 40% of the sector specific OEIC.

What about advisers?

Investors do not need advice to buy and sell ETFs. But those who have advisers should be made aware of Exchange Traded Funds. In June 2009, the Financial Services Authority (now the Financial Conduct Authority) told advisers that with the Retail Distribution Review (RDR), “to the extent that ETFs can be a cheaper and transparent way to invest in a particular market, these products should be considered when deciding which products are suitable for a retail client”.

Advisers often use ETFs to build positions that can be unwound and moved quickly and to create portfolios for investors wanting a cautious, balanced or adventurous approach but who do not believe individual active managers offer value.

Jonathan Wiseman, an asset manager at IFA Wealth at Work believes ETFs are one approach to the passive element in core portfolios. And they are a solution where there is no easily available fund – he cites, for instance, Mexico where holding a Mexico ETF avoids the concentration on a few Brazil equities in many Latin American funds – understandable due to the size of its market.

Nic Round, a chartered financial planner at Treowe Wealth Advisers, believes advisers cannot predict the future. He focuses on index tracking funds. While “in theory” he is not bothered whether the fund is an OEIC or an ETF, ETFs help avoid investment platforms. He cites their additional costs and fears some will not survive which could lead to at least some serious inconvenience for investors. He uses an online stockbroker – again to shave costs.

Advisers also use ETFs in rebalancing portfolios. So someone approaching retirement wanting to “de-risk” might move their S&P 500 ETF into a bond ETF such as a UK Government stocks vehicle in minutes.

What about the cost?

New research from Morningstar European Passive Fund Research Team – – shows ETF fees are lower than trackers for retail investors at least—with around some 40% of European large-cap equity index non ETFs charging private investors a TER total expense ratio in excess of 1% for merely tracking an index.

The report shows that because traditional index funds have a dual charging structure— one fee to private investors and another, usually lower, to institutional investors—they tend to be a cheaper for institutional investors compared to ETFs, which charge the same for all.

But not all ETFs are such great value. Morningstar states that although fixed-income ETFs charge less than index funds retail offerings, they have seen an overall increase in average TER (Total Expenses Ratio) since 2008 due to product specialisation and a lack of competition within the asset class.

Where could the problems lie?

Some ETFs can prove costly over time – especially if investors want to save on a regular basis when buying expenses can add up to more than traditional funds.

But the real upsets could come from exotic ETFs. A recent US Federal Reserve research paper US Federal Reserve paper is the latest to raise the possibility that ETFs could prove risky and lead to market instability. It concentrates on “leveraged” ETFs which aim to provide two or more times the return (up or down) on the underlying portfolio. These need to be rebalanced daily (or more often) leading to high costs as well as substantial risks.

The paper studied Leveraged and Inverse Exchange Traded Funds (LETFs) It shows that an increase of just 1% in broad stock-market indexes induces LETFs to originate rebalancing flows equivalent to $1.04 billion worth of stock.

It adds that price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks. This large and concentrated trading could be destabilising during periods of high volatility.

And while most ETFs are based on physical portfolios of the underlying investment, some are “synthetic” which replicate the performance of indices by using swaps put together by banks.

The Bank of England is worried about a growing shortage of high-quality collateral which is needed to underpin them. Its June 2013 Financial Stability Report states: “New risks may arise as market participants attempt to manage collateral more tightly – for example, by making greater use of innovative structures to save on their holdings of high quality collateral.”

There have been other warnings. And so far all has been well. But never say never in financial markets so there is the risk of some unknown and perhaps unknowable factor occurring which will destabilise these markets.

Some of these issues are actually at a systemic level i.e. central banks are worried about risk to the system in the wake of the financial crisis and are seeking to identify any vehicles that could cause problems or incorporate hidden contagion.

It may only give you specific problems if you are invested in a particular product that goes wrong and if it is a complicated one, then you should really deem yourself to be at the sophisticated end of the investment spectrum.

You may also hope that regulators spot any issues this time. Maybe these warnings are part of the process. But it looks as if every kind of investor is going to have ETFs in the portfolio.

1 thought on “ETFs – how they work, how to use them, the costs and the risks.”

  1. A.J Evans says:

    Thanks for the clarification! I use http://www.mutualfundstore.com/ right now, def thinking of switching up the portfolio to ETFs

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