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Samantha Downes finds that some advisers insist on full replication to invest in ETFs

Exchange traded funds are growing in popularity among advisers as they can offer low-cost exposure not only to global indices but also to commodities, currencies and even whole countries.

Walters & Shek managing director Stephen Walters says ETFs are an ideal post-RDR product for investors. He says: “The charging structure of ETFs is transparent and therefore easy for clients to comprehend, which is what the FSA is looking for.”

Defaqto’s insight analyst of funds Fraser Donaldson says demand for ETFs through platforms such as wraps has doubled in the past year. He says: “We expect this to grow considerably in the coming year.”

Although investors have a choice encompassing currencies, global indices and commodities such as oil and gold, the most popular ETFs remain FTSE-100-based.

Donaldson says: “We are finding that these types of ETF are core holdings for clients and the more exotic such as Brazil, for example, are being used as satellite holdings.

“ETFs do not have front-end charges, early redemption penalties or exit charges and service charges are often lower than 0.5 per cent a year. In terms of charging they are the purest form, all they have is an annual management charge.”

But while ETFs themselves are self-explanatory, there are fears that more exotic ETFs are lulling investors into a false sense of security.
Most advisers will only invest in full-replicated ETFs, ones that invest directly in shares, but most ETFs – over 90 per cent, in fact – involve a counterparty.

Walters explains that when a counterparty is involved, the ETF becomes far more complicated, with more risk involved and more complexity to explain to the client. A counterparty can take several forms such as leveraging, derivatives, futures or swaps.

Walters says: “There are 2,000 available ETFs and only 108 of them are fully replicated and these are the only ones we recommend to clients at the moment.”

Walters feels the unknown element of ETFs which are not directly invested in assets make them, currently unsuitable for many clients. “I do not recommend them, simply because I do not have clients who are yet sufficiently educated about ETFs and I think this goes for most UK investors.”

Smart Financial Planning managing director Steven Martin says an EFT which is 90 per cent shares and 10 per cent swap-backed may be as safe as a 100 per cent fully replicated version but over the longer term, there is still an element of risk that he does not want to expose clients to.

He says: “If you had bought a swap from Credit Suisse, of course, it would be safe but you only have to look back a couple of years, in the case of Lehmans, to see that there is a risk involved.

“If you have no counterparty and the manager of the ETF went bust, then you could, in theory, return the assets to the original investors. This is not the case if the ETF is heavily leveraged.”

Stock lending is also an issue of which advisers need to be aware.

Martin says: “Some ETFs use and lend to hedge funds so there could be problems if that hedge fund goes bust.”

The fact that some ETFs synthetically replicate the underlying investment being tracked can also lead to situations where the ETF becomes divorced from the asset or commodity being invested in. An oil ETF for example, might be invested in futures which do not directly track the cash oil price.

iShares head of sales strategy Nizam Hamid says ETFs which are not directly invested in assets can leave some investors feeling short-changed. He says: “The main use of these products has been for investors that are unable to access derivative markets and who need to use a Ucits-compliant product to manage exposure.

“The main issue that investors face is that, apart from on a daily basis, they do not provide the returns that many investors expect and this can cause mismatch between investors’ expectations and the use of these ETFs.”

Hamid says these types of ETFs can only be understood “through a detailed analysis of the prospectus for the specific funds”.

He believes the environment for “exotically backed” ETFs has probably reached a plateau. “This is evident from their relatively static share of overall assets, having peaked at 3.33 per cent of European assets under management they are currently around 2.8 per cent of European assets. In terms of trading, exotic products currently account for around 13 per cent of European traded volume compared with a peak of over 24 per cent in March 2009.”

’It is of critical importance that people do not assume ETFs are simple products. They are all different and all need to be researched’

He says all iShares ETFs remain fully replicated but that the company continues to educate investors in case this situation changes.

He says: “Although iShares does not have products that fall into this category, we have spent considerable time and resources discussing these with clients and helping them understand the nature of the embedded risks.”

Regardless of whether they are fully replicated, advisers claim the best EFT is one that is offered with plenty of advice.

Walters says because ETFs are shares, clients need to have the ability to sell quickly. He says: “When we discuss EFTs we do feel it is important that the client is able to sell the ETF as soon as the market drops, which is why we offer what we feel is top-class service.”

But not all advisers are convinced that ETFs even have a place in mainstream financial planning.

Martin says ETFs are better as a niche, rather than core, part of a portfolio. He says: “They have found a place in the UK investment market that they were never really meant for. If you are looking at investing in a low-cost tracker fund, you are better off investing in a unit trust.

“However, the commodity-based ETFs, ones that invest in gold and oil are more useful – for the intangible investment they are excellent. But investors need to understand them and I am not sure there is enough awareness yet.”

Gary Mairs, a partner at TCF Investment, says people looking for passive fund management can no longer ignore ETFs but they need due care and attention.

Mairs says: “Whether the ETF is fully replicated or not, I would say it is of critical importance that people do not assume ETFs are simple products. They are all different and all need to be researched. It is vital that due diligence is carried out in every case.”

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