Investors should be reminded that ETFs are tracker funds that trade on an exchange rather than with the manager directly. This gives ETFs significant advantages over traditional tracker funds.First, they have lower annual management fees. Morgan Stanley Fitzrovia last year calculated that the average total expense ratio for an ETF is 0.43 per cent versus 1.2 per cent for traditional tracker funds. They have no initial charge, other than dealing commission. When you deal for a maximum of £25 per bargain, as we do, this is hardly taxing. There is also no stamp duty, saving 0.5 per cent on UK funds instantly. Finally, they trade in real time during the exchange opening hours rather than when the manager fixes their valuation point. Of course, there is no expectation of outperformance of the index when buy- ing a tracker rather than an active fund but the opposite is also true – there is no underperformance of the index, either. Couple this with no initial charge, lower fees, the liquidity of ETFs, the sheer variety of available funds and the fact that we know the constituent shares, and we can deliver the type of return that we are aiming for to justify our own fees. The last point is probably the most important, in that we are trying to deli- ver a particular type of return without utilising other asset classes beyond equities, other than cash. Our stated objective is to deliver a total return of 2 per cent over Libor, a type of bench- mark that is becoming more common- place but with lower standard deviation or risk than equities generally. Using our proprietary software, the way we aim to achieve this latter part of the objective is through measuring share price movement and, therefore, the current level of demand attached to each share. The software then decides statistically whether the demand is too high and, therefore, high risk or too low and, therefore, low risk. As the constituent shares of each ETF are published by their issuers at the end of each day, we can then combine this data to give us a picture of risk for each ETF. We then tactically asset allocate among the ETFs that represent the best probability of delivering a low risk/reward in line with the fund’s objectives. The process works particularly well with the sector-based ETFs as the assets in these funds tend to be homogenous. The process picks up those asset shifts made by the active fund managers, say, from utilities to cyclical goods, depending on their view of valuations and the economic backdrop. If the process identifies no ETFs with the correct risk/reward profile, it will hold cash until one or more emerge. One final point about using ETFs with this process is that we do not have to concern ourselves with addressing stock-specific risk. We leave that to the stock pickers who are, after all, trying to deliver something completely different.
A war on several fronts can prove costly, as several generals have found out over the years, and life offices are now facing that scenario in the battle for assets.
Nationwide Building Society
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