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The ETF dream

If you believe the hype, you would be forgiven for thinking that exchange traded funds have become the investment choice of private investors or that they pose a serious threat to the mutual fund industry.

But while overseas investors, particularly in the US, have embraced this cheap and flexible way of investing, private investors on these shores have been a little more reluctant. Retail investors currently account for fewer than 10 per cent of UK ETF trades.

I have often wondered why more investors have not cottoned on to their benefits. They are deemed to be cheap, transparent, liquid and give investors access to markets they would otherwise only dream of.

Is it because investors have been misled into thinking that they are esoteric and complex investments? Or is it a lack of education? Personal finance sections week in week out describe how to invest in a unit trust, ETFs are lucky to get a once-in-a-year outing. Or are advisers to blame for overlooking their merits?

Talk to those in the ETF industry and they reckon that advisers and our regulatory system are a major barrier. They argue that advice is often product-led, particularly in the tied or multi-tied sector, and so ETFs rarely get a mention.

Perhaps that is about to change. When ETFs emerged in the US in the early 1990s, advisers were sceptical and were concerned about the lack of commission or rebates available to them. Yet today, 40 per cent of ETFs traded in the US are from retail investors.

The difference is the fee-based adviser community. A study in the US reckons that the increased use of fee-for-service invest-ment advice will help push the amount of cash into ETFs over the $1trn mark in two years.

New York fund research firm Strategic Insight says ETFs are benefiting from advisers moving into “a compensation model that favours fees for advice instead of point-of-sale commission”.

It is why ETF players, notably BGI and ETF Securities, are pinning their dreams on the RDR because ETFs are not “currently part of the tied or multi-tied product” sets. With commission bias removed, transparent costs and an increase in the number of fee-based advisers, the investment product playing field becomes more even. Truly independent advice will have to offer the best and most suitable products, irrespective of financial incentives, which will fall into the hands of the ETFs, so the ETF advocates say.

To be fair, many advisers have started to embrace ETFs as they reckon they add to an investor’s armoury. You can access just about any market you want.

But ETFs are not without their issues. Retail investors getting access to leveraged ETFs is a potential banana skin, as a one percentage point fall in the market could be a two percentage points loss to a fund. The worst performer in the past year was the ETF Securities’ leveraged nickel fund with a 90 per cent fall.

Counterparty risk is also a concern. Some exchange traded investments have counterparties, some use derivatives so they will have counterparty risks attached while some funds lend out portfolios to hedge funds and, let’s face it, one or two have been known to go bust.

ETFs will continue to grow in popularity and will continue to be cast in a positive light but as the market grows, more sophisticated products will emerge and that could cause more harm than good.

Nor will the RDR transform advisers’ opinion of ETFs overnight unless they have been kidding us all along that active management delivers greater value.

Paul Farrow is digital personal finance editor at the Telegraph Media GroupMoney Marketing

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