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In the twinkling of iShares

Exchange traded funds are gaining popularity with some investors but how do they work?

Our landlord wishes to retain a deposit as part of the lease on our property for 10 years. We clearly would prefer that this was not held on deposit and have heard that exchange traded funds could be used as an alternative. What are they?

In normal circumstances, deposits are placed in a bank or building society account, with any interest accumulated becoming payable to the tenant, depending on the terms of the lease. Recently, exchange traded funds have gained popularity as an alternative form of investment.

ETFs are collective investments representing immediate access to a diversified portfolio through the purchase of one single share.

They were developed in the US where they are listed and traded as securities primarily on the New York stock exchange.

The first exchange traded funds in Europe were launched on the Deutsche Borse. On April 28, 2000, the UK’s first exchange traded fund was launched on the London stock exchange – iFTSE100.

Last year, the London stock exchange became the world’s first exchange to offer a multi-currency trading service for ETFs, giving investors a tax-efficient and currency risk-free alternative to buying ETFs in the US markets.

In general, ETFs are passively managed which means that the stocks held within the fund are determined by an index, offering a simple and transparent means to equity ownership. They aim to do it by fully replicating the shares in a particular index, giving a very small tracking error.

With ETFs, you can invest in major global and European indices such as the FTSE 100 and S&P 500. A great deal of diversification can be achieved by investing in indices geographically, by sector and by segment, using bonds and even commodities.

The ETFs, known as iShares, currently trading on the London stock exchange are categorised under the following headings:-

– Government bonds.

– Corporate bonds.

– Emerging equity.

– Equity income.

– European cap/style equity.

– Property.

– Developed equity.

The most well-known iShare is still the iShares iFTSE100 which tracks the FTSE 100 index. There are also the iShares S&P500, which tracks the S&P 500 index in the US, plus other funds which follow other major global markets.

Existing UK ETFs at the London stock exchange trade on Sets (Stock Exchange Trading Services) and settle in Crest electronically. There is no paper-based certification or settlement. They have the lowest annual charges of all collective investment schemes and therefore investors benefit from the economies of scale available to the entire scheme, with annual costs in the region of 0.5 per cent.

An EFT trades at a price that is very close to the exact value of the underlying stocks. Unlike other collective investment schemes, ETFs do not incorporate charges within their secondary market pricing mechanism. The share price will reflect the underlying value of stocks and market movement, meaning that stockbroker and adviser ees are charged on top of the share price.

ETFs, like any share on the market, trade continuously throughout the day within market hours. This means there is price transparency in real time and investors can see the value of their investments before, during and after any decision to trade.

Last year’s pre-Budget report issued a proposed change to the stamp duty reserve tax paid on trades of ETFs. It is proposed that, with effect from February 1, 2007, the exemptions to stamp duty reserve tax are widened to include providers of EFTs that are incorporated outside the UK and which wish to list on a UK exchange and investors in those funds. ETFs incorporated in the UK will continue to be subject to stamp duty reserve tax in the same way as shares in other UK companies and this should be borne in mind when making recommendations.

ETFs can be held within an Isa, subject to ISA limits and therefore dividend payments and capital gains will be free of tax although tax credits cannot be reclaimed.

ETFs held directly by UK taxpayers are subject to capital gains tax and income tax on dividends for UK ETFS. Overseas funds will also be subject to the tax treatment of ETFs in the country in which they are domiciled and this also needs to be clarified by the adviser before any recommendation is made.

Lisanne Mealing is a director of MDM Associates.

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