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Are ETFs on the right track?

Exchange traded funds are making a break for the mainstream but their success in the UK lags behind the US.

ETFs have broadly been the preserve of experienced traders but the forthcoming launch of a fund of ETFs by Raymond James Investment Services will enable IFAs to earn commission on the products for the first time.

Four years after their launch, the average number of monthly trades of ETF shares rose to 223 million in 2004, with Germany accounting for 45 per cent of overall volumes, followed by the London Stock Exchange, where 23 per cent were bought and sold, according to Lipper.

In the US last year, ETF assets grew by 47 per cent to $222bn, according to Morningstar. This dwarfed Europe’s take-up but was still way behind the $7.9trn held in US mutual funds.

Barclays Global Investors was the first fund manager to launch ETFs, branded i-Shares, in the UK in 2000.

EFTs are effectively listed real-time trackers with low charges that provide an efficient means of gaining exposure to certain indices.

The products are open-ended funds that are listed on stock exchanges and traded as shares. Like both unit trusts and investment trusts, they can be held in Isa and Pep tax wrappers but they have certain advantages over these more traditional vehicles.

Besides typically being cheaper than investment trusts and unit trusts, ETFs are more cleanly priced, not having the bid/offer spread of unit trusts or the discount problem that bedevils many investment trusts. Plus, they are instantly tradable.

BGI offers 14 i-shares which track a range of indices, such as the FTSE 100, S&P 500, MSCI Japan and corporate bond indices. Recent additions include the FTSE Xinhua China 25 index.

In the more developed US market, which is served by an array of providers, investors can buy exposure to specific sectors, such as pharmaceuticals, technology and commodities such as oil and gold.

Raymond James marketing director Tim O’Connor says ETFs are superior to traditional tracker funds in many ways.

He says: “They are readily accessible, tradable instruments and ideal for anybody looking for exposure to a specific index. The tracking error tends to be very explicit and they are much cheaper than trackers.”

BGI’s ETFs have effective annual management charges of between 20 and 40 basis points, with the exception of the China ETF which levies 74 basis points. Traditional tracker funds typically charge a 1 per cent annual management fee and have a slightly higher tracking error as they have to physically own the stock and keep trading it to mirror the index as constituents fall out or come in. ETFs normally use futures to replicate the index, which is more efficient and requires fewer transactions, keeping total expense ratios down.

The low cost of ETFs is a major reason why the products have not really taken off in the UK, as the low annual management charges mean there is no obvious way of paying up-front commission, let alone trail.

BGI head of product strategy Mark Roberts notes: “I think it is safe to say ETFs are not synced up with how the advisory model works today. In the US, though, where we have been able to watch their development longer, we are seeing a shift away from commission-based models and a notable move to fees.

“It is in everyone’s interest to find the lowest-cost products you can, so ETFs are well positioned for the current situation.”

Hargreaves Lansdown head of research Mark Dampier is not a big fan of trackers, being a long-term advocate of selecting quality stockpickers with proven track records and processes, but he accepts that passive investing has its place.

Dampier says: “ETFs are a clever invention and probably underused. One problem generally is that I am not a great believer in trackers. If you do get the asset allocation right, it is a low-cost way of doing it though.”

With the typical use of ETFs seen as being for asset allocation purposes, they have broadly been seen as a tool for the sophisticated investor looking to balance their portfolios. Strangely, given that they largely do the same job, trackers have been viewed as the preserve of the less sophisticated investor looking to dip their toes into the equity markets.

Roberts says: “It is an interesting split but probably not really fair to characterise either product that way. A lot of people have come to view passive investing as part of the approach to portfolio construction.”

He welcomes the forthcoming launch of the Raymond James fund of ETFs as it will raise the profile of the asset class and potentially broaden the user-base.

Chelsea Financial Services managing director Darius McDermott says the proof of the product will be in its performance. Few global growth or managed funds repeatedly outperform their benchmarks, he adds, so the product could be of interest to direct clients. Like Dampier, he typically favours stockpicking portfolios.

Another issue raised by McDermott is that the Raymond James fund of ETFs will have to deliver significant outperformance to justify its expected 1.5 per cent annual management fee.

He says: “They are going to be charging an extra 1.5 per cent on top for the active risk modelling but the TER will still be cheaper than on funds of funds. It is innovative to see a fund of ETFs but we would want to make sure clients are not paying too much for this extra layer of tactical asset allocation.”

If the Raymond James fund is successful, the industry may see copycats enter the market but, for the time being at least, it seems ETFs have some way to go before winning over advisers. They will struggle to compete with managed and multi-manager funds, commission or no commission.

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