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Diamonds are an investor’s best friend

By whatever name they are known, exchange traded funds can be the jewel in the crown of any portfolio by offering a low-cost element of index tracking, freeing up the active managers to concentrate on outperformance, says Seven Investment Management marketing director Justin Urquhart Stewart

Exchange traded funds are one of the best kept secrets in our industry. They emerged in the US in 1993 and quickly developed their own style of acronyms such as Spiders (S&P Depository Receipt), Diamonds (Dow Index Industrial Average) and Cubes (from the Nasdaq’s QQQQ ticker symbol).

They have become the most traded stocks on the US market while BGI is now developing its iShares range in the UK. Yet many UK fund managers, advisers and stockbrokers have been remarkably snooty over this innovation. Why?

Effectively, these instruments can track any index while providing a greater level of flexi- bility than traditional trackers, at low cost and with immediate trading and settlement via Crest in the UK . Compare that with the more laborious process with a unit trust tracker.

It is as if they are looked upon with disdain by some because they are seen as mere trackers. But this is to miss the opportunity that such investments can provide.

The range of ETFs has proliferated since 1993. At my last count, around 400 ETFs with a value in excess of $314bn were traded on 32 exchanges.

ETFs were originally tied to equity indices but have broadened out to include asset classes such as fixed interest as well as commodities and property. The entire range of ETFs effectively allows managers to build diversified multi-asset portfolios entirely from these funds.

The benefits offered by ETFs include investment flexibility, a broad choice of asset classes and geography, ease of trading and settlement and low charges. It is true that some open-ended tracker funds can be as cheap as some ETFs but their real beauty comes from the combination of flexibility and low cost.

Sadly, many active managers have built high cost bases supp- orted by generous charging systems with healthy margins. This has provided excellent inc- ome for investment houses but seemingly thin benefits for intermediaries or their clients. I believe the more aware investment houses will make changes in this respect although the fact that they do not pay introductory or trail fees will no doubt dissuade certain advisers.

Compared with the retail charges levied by active fund managers, ETFs can start as low as 0.09 per cent although a range from 0.2 to 0.7 per cent is more normal.

At the core of many a portfolio will be certain benchmark holdings. Where there is a benchmark, you are likely to find an appropriate ETF.

The worry of achieving benchmarks has been borne by investment managers for years. It is all very well relying on expensive active managers to exceed their targets but, all too often, after charges, you can end up with what looks like an expensive tracker.

Why not put ETFs at the core of your portfolio to achieve benchmarks very cheaply, then deploy talented active managers to do what they are best at, by trying to out-perform in their specialisations rather than performing against an index?

As markets react to the world around them, you too will need to make tactical changes and adjustments. But if you change your active managers too frequently, their goodwill to you as an investor might be worn thin. So do not go the effort and expense of changing your core active managers unless significant adjustments are called for. Why not make very targeted tactical changes by using your range of ETFs to emphasise any appropriate asset class, country, sector or industry in the portfolio? The passive ETF route can thus complement the talents of your active managers.

Just look at the recent example of the terrorist outrages in London on July 7, when the market went into turmoil. If you wanted to adjust your positions, it was difficult to trade funds, while the spreads on many securities were getting broader. However, continuously priced and tradable ETFs allowed man- agers to act during the day to protect and even enhance client portfolios. Thus, in a time of uncertainty, ETFs showed their true value and strength.

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