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Fair exchange

Exchange-traded funds are one of the most rapidly growing products in financial markets. No longer confined to the US, where assets under management have grown to over $70bn (£48bn), they are emerging as popular investments for institutions and private investors in Europe.

With unusual names such as LDRS (pronounced Leaders), Frescos and iShares, they are set to make significant inroads into the UK market in the next few years despite currently being a well kept secret from most British investors.

Although some investment houses have issued actively managed ETFs, the phenomenal success they have achieved in such a short space of time has almost entirely been attributable to products linked to popular blue-chip indices such as the Dow Jones Euro Stoxx 50 or the FTSE 100. Their popularity has been fuelled by low management fees and the tax breaks that UK investors in particular can enjoy.

Like investment trusts, index ETFs are funds traded on stock exchanges exactly like a single share, at a market price that closely follows the value of the underlying index. Unlike investment trusts, ETFs do not trade at a discount or premium to net asset value and they provide investors with a highly liquid, diversified portfolio at low cost.

A further benefit to the investor is a fully transparent investment strategy – the components of the ETFs are disclosed every trading day, in contrast to traditional mutual funds which are required to reveal their portfolio only twice a year.

Also, the ability to trade ETFs intra-day at a known price gives them the specific characteristics of an equity, in contrast to a retail unit trust where buying and selling is subject to the uncertainty of once a day dealing at a “forward” price.

The first ETF was launched in the US in 1993. By 1997 there were 19 ETFs with a market capitalisation of $6.7bn (£4.6bn) and today there are 102 products with assets in excess of $81bn (£56m). The three largest products, the S&P 500 linked SPDRS (Spiders), Nasdaq 100 linked QQQ (Cubes) and the Dow Jones Industrial Average linked Diamonds account for over $53bn (£37bn).

Average daily share volume accounts for 55 per cent of all daily equity trades by volume and the Cubes product turns over completely on average every three to four days. To put this into perspective, the daily trading volume of ETFs in the US often matches the total daily turnover of the London Stock Exchange.

In Europe, 72 ETFs, listed on six exchanges account for over e6.5bn, a figure which has increased by 50 per cent in just four months. This growth has seen assets in Europe take 18 months to reach levels that took five years in the US.

Average daily turnover grew ten-fold in 2001 to reach e200m based on the London Stock Exchange&#39s Extramark platform, accounting for 5 per cent of the European market for ETFs – a share that has risen rapidly, with turnover doubling each month for the last quarter.

The most successful ETF in Europe is the Merrill Lynch LDRS Dow Jones Euro Stoxx 50 contract, which currently has

a market capitalisation approaching e1bn and is listed on extraMARK along with 13 other ETFs including Barclays&#39 iShares FTSE 100 product.

Largely due to the huge interest in cross-border investing since monetary union in 1999, Dow Jones and Stoxx indices account for a whopping 45 per cent of European ETF assets.

There is an increasing move by investors to sector ETFs based on indices tracking European financials, pharmaceuticals and technology stocks reflecting sector preferences elsewhere in investment circles. The move to global investing, the logical next step after country investing to regional investing, is also gaining popularity as global products linked to the Dow Jones Global Titans 50 capture market share.

So what are the reasons for this rapid growth in popularity for ETFs? For investors, ETFs are cheap, transparent, quick and simple to buy – you do not have to complete a long form and you can buy and sell within a day.

They are bought like shares through a stockbroker. They also pay a dividend and are tax efficient – you can put them in an Isa, Sipp or Pep and, unlike other shares, you do not have to pay stamp duty when you buy them.

No share certificates are offered as they are only available in dematerialised form to nominee or Crest sponsored accounts.

Annual management charges range from 0.3 to 0.5 per cent and spreads, because ETFs have huge liquidity, are very narrow – in the case of the popular blue-chip indices, often less than 0.2 per cent.

These management fees are probably the lowest for any financial product on the market and compare very favourably with retail index tracking unit trusts, which can charge up to 5 per cent up front and 0.75 to 1 per cent in annual management fees.

The main reason for these low management fees is that ETF managers only create large numbers of new shares when institutional investors make available the component shares of the index. These shares are then packaged by the big providers and turned into ETF shares.

When a big investor wants to sell ETF shares then the providers simply hand back shares to the sellers. This reduces the handling of cash and so in turn the brokerage costs for buying and selling.

So what of the future? In the US, so often the crystal ball for equity investment trends in Europe, product issuers already offer ETFs linked to a variety of underlying indices. These blue-chip, broad market, style and sector indices give investors a full range of investment strategies from which to choose and much the same product choice is expected in Europe in the coming months.

Many stockbrokers now believe that ETFs are a hidden treasure because of their costs, transparency and simplicity. It will not be long before the secret is out.

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