Fair exchange

January Retirement Strategy

Although the global exchange traded fund market is approaching $1tn, these tracker products have yet to achieve mainstream status among UK investors.

This is despite several attributes, including liquidity, transparency and the simplicity and lower costs of accessing markets and other assets via a single transaction. Simply put, ETFs combine elements of mutual funds and shares - offering a pooled structure available to buy and sell like any listed company and exempt from stamp duty.

As shares, ETFs have been unable to pay commission and many commentators expect additional demand after the retail distribution review, which will move more advisers to charging fees. These products are eligible within the share portion of a Sipp, offering an alternative to tracker funds for pension investors seeking a passive element.

ETFs began life focusing on basic equity indices but now cover every conceivable benchmark, with growing numbers of bond, cash and commodity offerings as well as short and inverse products.

Most providers position them as portfolio building blocks, playing to the increasingly accepted wisdom that asset allocation determines the bulk of investment returns.

As financial planning becomes more sophisticated, many see these products playing a key role as investors seek to separate alpha and beta - effectively excess returns through active fund management and basic market performance.

In a report for US firm Index IQ, the group’s chief investment strategist Robert Whitelaw said the rise of index funds has shown that achieving beta is inexpensive and easily achievable. “For most investors, alpha and beta are inseparable when you buy a mutual fund for example,” said Whitelaw. “But the most sophisticated are now decoupling the two. We spend hours trying to figure out how to beat the market but the most important thing from a return perspective is making sure we are in it - getting market-level returns for market-level risks, preferably at low cost.”

ETFs have established themselves as a cheap way of achieving this beta, offering access to most of the assets and sectors required. Most advisers use them as part of a core-satellite approach alongside active products. According to Manooj Mistry, head of db x-trackers in the UK, ETFs can meet either requirement as necessary.

Mistry says: “For a low-cost passive core to portfolios, ETFs can provide cheap beta from the larger markets and free up advisers to seek out active managers that genuinely add value. It means clients no longer have to pay active fees to underperforming managers giving little more than beta.”

Meanwhile, if advisers have core funds where they believe managers can perform, ETFs can also serve as satellite plays to express particular sector or geographical bets.

Premier Wealth Management managing director Adrian Shandley is a strong advocate of these products, as they allow him to asset allocate without taking on stock or fund manager risk Shandley says: “We establish a risk profile for clients in terms of allocations to certain asset classes and find ETFs an effective way of achieving that by taking managers out of the equation. Our view is that even the best funds can suffer periods of underperformance, typically for non-investment reasons, and clients fear loss more than they want alpha.” Shandley believes an IFA’s role is moving towards risk and cost management for clients and ETFs provide a cheap investment package offering returns in line with the market.

In comparison with tracker funds, ETFs have traditionally been seen as much cheaper although this is largely a thing of the past as groups have slashed fees on the latter.

David Chellew, head of market position at HSBC Global Asset Management, said before recent cuts, the average cost of a passive fund was 80 basis points while an ETF was 30. He says: “Now that disparity has gone, the argument basically focuses on access. Most advisers still deal with funds rather than listed securities with a stockbroking account needed to trade in shares.

This means that ETFs are currently more difficult to access unless the client uses a whole of market wrap while trackers are listed on most major platforms.” Chellew highlights the commission skew against ETFs although this will soon disappear under the RDR.

He says: “Fund platforms take commission rebates from groups but will no longer be able to do so when the remuneration system changes. This means that we will likely see a rush to change their models to a wider wrap, including share dealing capacity, so ETFs will be available through these key distribution channels.”

 

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