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GUIDE TO EXCHANGE TRADED FUNDS ◗ P or
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A
nyone who has read the financial press
regularly over the past couple of years
might be forgiven for believing that a
Contents
wholesale shift in investment patterns
by private investors is underway, as they
increasingly focus their attention on
4 ABSOLUTE
BEGINNERS
ETFs can often be cheaper
cheap, liquid, transparent exchange traded funds (ETFs) in than trackers and offer a
preference to conventional collective funds. wider choice of markets,
making them well suited
However, the statistics tell a slightly less clear-cut story. to asset allocation
On one hand, global ETF assets under management reached
$1 trillion (£656 billion) by the end of 2009, up 45 per cent
over the previous year against the MSCI World index rise of
27 per cent. There are now more than 1,900 ETFs available
7 TYPES
OF ETFs
ETFs are available in a
worldwide through 109 providers, listed on 40 exchanges. wide variety of shapes
and sizes. We show you
But the use of ETFs in the UK has been concentrated which ones are worth
primarily among institutional investors. A 2009 poll of shelling out for

9 SHORT
independent financial advisers by ETF provider iShares and &
wrap platform Ascentric found that only 19 per cent of UK leveraged
advisers use ETFs on a regular basis, although 94 per cent of Leveraged and short ETF
those polled expected their use of the products to increase products are not for the
faint-hearted, and there
over the coming 12 months. are traps that await the
Much of the resistance to greater incorporation of unwary
ETFs in client portfolios is to do with the fact that advisers
themselves are wary. The poll found that 85 per cent of IFAs
not currently using ETFs felt they don’t know enough about
10 nuts
Bolts
&

We get under the bonnet

them or find them difficult to access. (Of course, the fact of ETFs and explain the
that ETFs don’t pay commission to advisers doesn’t help fees you are likely to pay,
their different structures,
either.) And if financial advisers feel they are ill-equipped
and any risks involved
to guide clients this way, it’s unsurprising that many

12 portfolio
mainstream DIY investors also remain on the sidelines.
This guide aims to get rid of some of the mystique Strategies
surrounding these useful investment tools. We start from By using ETFs with
first principles, looking at how they work and the various actively managed
funds, you can add
assets to which they give access, their strengths and
diversification and keep
shortfalls for new investors, and some of the ways that costs down
they can be used strategically by private investors as part
of a wider portfolio. Editor Andrew Pitts | Written by Faith Glasgow
Art editor Chris Aldridge | Production Gary McFarlane
And when you want to track how ETFs are getting on,
Published by Moneywise Publishing, Standon House,
each month Money Observer provides regular commentary 21 Mansell Street, London E1 8AA. Tel: 020 7680 3602
and performance details for all UK-listed ETFs and Advertising manager Trevor Leek
Web: www.moneyobserver.com
exchange traded commodities in its Analyse Money section.
E-mail: editorial@moneyobserver.com
Faith Glasgow

Money Observer ◗ Exchange Traded Funds ◗ May 2010 3

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STARTING OUT

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Passive Exch
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Exchange traded funds can be slightly cheaper than

n
trackers and offer a wider choice of markets, making ha
them well suited to asset allocation for new investors Exc s
and those less enamoured of the actively managed path

D
espite the publicity that very much a known quantity, which is more
exchange traded funds than you can say about most managers,’ he
(ETFs) have generated, observes.
it’s unlikely that many If you accept that basic premise, you’re
investors new to the stock faced with a choice of ETFs or tracker funds,
markets and looking for both of which are effectively ‘buying the
sensible introductory market’ in question rather than attempting
exposure would turn to them as a starting to pick and choose among constituent
point. More likely choices stocks. Both are low cost, but
would be either an index “We use ETFs according to Stuart Fowler,
tracker fund or a ‘populist’
actively managed unit trust and trackers managing director of financial
adviser No Monkey Business:
or open-ended investment
company (Oeic).
depending on ‘For private investors, most
ETFs are marginally cheaper at present, ETFs are markedly cheaper than
So the first question that
any novice investor should ask
the market we than trackers.’
Hall points out that some
unit trusts or Oeics.’
However, Darius McDermott, managing
themselves is whether or not want to follow” tracker funds available to the director of Chelsea Financial Services,
they subscribe to the widely
held belief that most active
Dennis Hall institutional market have
been quite aggressive in their
highlights the impact of dealing charges.
‘If you pay £10 or £15 per trade and you're
fund managers will fail to outperform the pricing – Vanguard, for instance, charges just investing large sums, that's really not too big
market over the long term, and therefore that 0.15 per cent, making its funds an attractive an issue, but in small quantities of £2,000 or
the bulk of their portfolio might as well be in alternative to ETFs. ‘We use both ETFs and £3,000, which is what many new investors
cheap, passively run funds that simply mirror trackers, depending on which market we are likely to be spending, it bumps up the
the chosen market index. want to follow – we just look at the price of total cost by maybe 0.5 per cent,’ he warns.
As Dennis Hall, managing director of the available funds on the day,’ he explains. Investors comfortable with the index-
Yellowtail Financial Planning, points out, ‘For example, for the FTSE 100 we’d probably tracking approach, or keen to create a decent
such a strategy solves the very real problem use the L&G or HSBC index trackers because long-term ‘core’ for their portfolio onto which
for newcomers of how to choose from the they are a little cheaper. But in more esoteric they can later bolt other fancier investments
galaxy of active fund managers. ‘An index is markets such as Brazil, which is very popular (maybe actively managed funds), need to

4 Money Observer ◗ Exchange Traded Funds ◗ May 2010

han Private investors need helping hands
Why, given the wide-
spread use of index track-
ers as long-term core holdings
“The problem
by newcomers to the stock
markets, do ETFs remain the
is how to
create the right
ge
province largely of relatively
sophisticated or active private
investors? A key consideration portfolio for
is that only fee-based financial
advisers and discretionary
your needs”
ha John Lang
traded
wealth managers, looking to
keep client costs down, are
likely to utilise them on a regu-
ng

lar basis at the moment. Com- ‘ETFs would work very well iShares recognises there is
e traded fu

mission-based IFAs generally
steer clear of them as there’s no
trail commission to be earned.
That is likely to change
with the implementation of
the Financial Services Author-
n ity's (FSA) Retail Distribution
Review in 2012, which will mean
advisers wishing to be con-
sidered ‘independent’ have to
f
for many private investors –
the big question is, how do
they find out what they need
to know about them? Most
financial advisers will suggest
that something else would be
better,’ comments John Lang.
‘The problem for new investors
without an ETF-friendly adviser
is not the use of ETFs per se,
some potential in the idea of
pre-combining ETFs to broaden
mass market appeal. ‘We
already have a "fund of ETFs"
proposition in the Netherlands,
and we are looking at introduc-
ing something similar else-
where, including the UK,’ says
Nizam Hamid, head of sales
strategy for iShares.

un charge clients on a fee basis. It’s

probable that ETFs will become
more widely used by advisers
after that date, particularly as
they are highlighted by the FSA
as one of the investment tools
suitable for retail sales because
they are ‘a cheap and transpar-
ent way to access the market’.
but how to combine them so as
to create the right portfolio for
their needs,’ he adds.
In this respect, he suggests
that ETF providers could help
both advisers and DIY investors
by creating combinations of
funds in packages to suit differ-
ent investor requirements.
However, he makes the
point that these funds are
extremely adaptable building
blocks that can be used for all
sorts of asset allocation strate-
gies. ‘We’re working with advis-
ers to help them understand
how ETFs can be used for asset
allocation purposes,’ he adds.

think in terms of global diversification and a
good spread of markets.
John Lang, managing director of
independent financial adviser Tower Hill
Associates, points out that both equities
and fixed-interest markets can be accessed
via ETFs. The client’s attitude to risk and
age will determine the proportion in each;
then the equity portion can be broken down
regionally using broad market trackers. ‘We
would put say half into a FTSE All-Share
ETF; there is a developed countries ex UK
product that could be used to get exposure to
the US, Europe and Japan with a single fund;
and we’d also put maybe 10 per cent into an
emerging markets ETF,’ he says. ‘A simple
global portfolio of bonds and equities could
be constructed with just five or six ETFs.’
Hall suggests a portfolio of up to 12 ETFs
in order to tap into a mix of major and
smaller equity markets as well as gilts and
bonds. ‘ETFs are particularly attractive at the
moment because right now it’s very difficult
to find managers with any conviction over
where the markets are going,’ he adds.
Once you have decided where you want to
invest, which ETF should you choose? There
are several major players in the UK ETF
market, led by iShares, but also including
db x-trackers (from Deutsche Bank) and
Luxembourg-based Lyxor. So there may well
be a choice of funds doing much the same
thing. Both Lyxor and db-x, for example, offer
a MSCI Emerging Markets ETF.
‘In such cases, look at the charges, which
may vary; then you have to look at the
tracking error of the ETF relative to the
index [which should be as small as possible,
indicating greater accuracy of replication and
lower costs],’ advises Lang.
One thing to bear in mind when making
your choice is that not all ETFs actually
replicate the index they follow. Many do,
but some use a more complicated swap-
based system (see page 10). But advisers
recommend new investors stick to the more
straightforward index replicators. ‘We tend
to stick to simpler non-esoteric stuff, partly
because of the additional counterparty risk
involved with the others but mainly so that we
can explain to clients in simple terms exactly
what they’ve got,’ says Hall.
Ultimately your choice or rejection of
ETFs as an introduction to the stock market
is likely to be grounded in whether or not
you accept the fundamental premise that
long-term outperformance through active
management is overpriced pie in the sky.
As Darius McDermott observes: ‘I have
nothing against them – if you want to track
an index, ETFs are a good way to do it,
though you need to watch dealing charges.
But if you’d bought a FTSE 100 ETF at the
beginning of 2000 and held it through to
the beginning of 2010, you’d have lost 22 per
cent. If you’d invested your money with Neil
Woodford and his Invesco Perpetual income
fund, you’d have gained 102 per cent. Most
active managers didn’t do that well of course,
but many made some gain.’

Money Observer ◗ Exchange Traded Funds ◗ May 2010 5

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Single-country
ETFs

Style ETFs Fixed interest ETFs Currency ETFs

Regional
Commodity ETFs Short ETFs Sector ETFs ETFs

Pick of the bunch

ETFs are available in a wide variety of shapes and sizes tracking commodities and
stock markets. We show you which ones are worth shelling out for

I
ndices can be created to track all sorts
of assets and markets, from the broad-
based to the highly specialist, and
once you have an index it’s possible to
launch an exchange traded fund (ETF)
on the back of it. We take a look at a
selection of the most common ETF
types and the markets they follow.
spective within the eurozone through funds
tracking the Euro STOXX index. The iShares
Euro STOXX 50 provides exposure to 50 of
the largest companies across the eurozone.
It has gained 57 per cent over the past year to
1 March. But there are alternatives if you’re
looking for broader alloca-
tions, for example to create “Emerging market
It has gained 65 per cent over the year.
However, some of the most popular geo-
graphical ETFs over the past year have been
single-country emerging market products.
‘Emerging market ETFs have seen greater
inflows than all the local and developed world
ETFs combined over the last
year,’ says Hamid.

Geographical ETFs
These take various forms. Many UK inves-
tors use ETFs following local single-country
indices to get exposure to the stock markets
of their home country or other developed
markets. According to Nizam Hamid, head of
sales strategy at iShares, around three out of
iShares’ top 10 sellers tend to be local country
funds, although the past year has seen inves-
tors moving money out in favour of emerging
markets.
The iShares FTSE 100, which tracks the
performance of the 100 most highly capital-
ised blue chip companies traded on the Lon-
don Stock Exchange, is an obvious example,
but broader coverage of the UK market could
be gained by using a FTSE All-Share ETF from
Lyxor and db x-trackers.
It’s possible to take a more regional per-
a simple but highly diversi-
fied portfolio. The Pacific ETFs have seen The choice includes Bra-
zil, Korea, Taiwan, India,
ex Japan, North America,
Europe and Latin America
greater inflows than Turkey and Vietnam, and
there are three broader
are available through
iShares, or you could fol-
all the local and Bric packages from iShares,
Claymore/BNY Mellon and
low the FTSE Developed developed world SPDR, but all offer different
World ex UK index through
iShares or the MSCI Emerg- ETFs combined” weightings for country allo-
cations. One that has proved
ing Markets index through Nizam Hamid particularly popular is the
iShares, Lyxor and db-x. iShares FTSE/Xinhua China
At the top of the regional pile is the MSCI 25 ETF, which gives exposure to 25 of the larg-
World index, for which ETFs are available est and most liquid Chinese stocks trading on
from iShares, Lyxor and db-x. This index the Hong Kong Stock Exchange. It is up 70 per
offers exposure to around 1,700 companies in cent over the past year.
more than 20 developed countries worldwide. ETFs tracking the Brazilian market have
The iShares fund does not hold positions in done outstandingly well too. The iShares
the entire index, but takes the ‘optimisation’ MSCI Brazil fund, which also follows an opti-
approach by including a diverse mix of stocks misation approach, tracks the performance of
representing around 85 per cent of the market. more than 50 diverse large and mid cap com-

Money Observer ◗ Exchange Traded Funds ◗ May 2010 7

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THEMES AND SECTORS

If you’re keen to
follow the rising fortunes
of a specific industry sec-
tor – say financials – you can
do that by buying a sector
For the environmentally
conscious, iShares
offers the Global
Clean Energy ETF
ETF. db-x has a range of sec-
tor products, including DJ
STOXX 600 Banks (which
gives exposure to the leading
banking companies across
western Europe) and DJ
STOXX 600 Insurance, both
of which have more than
doubled in the past year.
Other sectoral ETFs
include healthcare, food,
technology and industrial
goods from db-x, while
iShares runs regional prop-
erty products following the
FTSE/EPRA indices.
iShares also offers sev-
eral thematic ETFs that
track the various indices
of the S&P Global The-
matic Index series,
which is designed to
provide investors with
exposure to a range
of emerging invest-
ment themes. iShares’
S&P Global Clean Energy
iShares' Timber Forestry ETF tracks 25 wood and timber firms
ETF tracks the performance
of 30 of the largest listed
companies involved in clean
energy technology, produc-
tion, or equipment provision.
It returned 33 per cent over
the year to 1 March.
Other S&P global the-
matic index themes in ETF
form through iShares include
Emerging Markets Infra-
structure, which focuses on
30 large emerging market
companies in the transporta-
tion, energy and utilities, and
Timber Forestry, which pro-
vides access to 25 timber and
wood product companies.
It’s also possible to track
water, shipping, nuclear
energy and listed private
equity companies, as well as
Sharia-compliant companies
on a regional or global basis.

panies representing around 85 per
cent of the Brazilian market. It has gained 116
per cent over the year.
Style
Some ETFs, labelled as style products, that
provide other tools to drill down further into
specific market subsets. It’s possible, for exam-
ple, to invest in indices created on the basis of
market capitalisation, dividend payment or
value or growth characteristics.
‘The STOXX indices offer a range of
European style ETFs, including MidCap,
Growth and Value, while the iShares FTSE
UK Dividend Plus focuses on the perform-
ance of the 50 highest dividend-paying UK
stocks,’ explains Nizam Hamid. The latter has
returned 55 per cent over the past year.
Fixed interest
iShares dominates the fixed interest ETF mar-
ket in the UK, with more than 25 products,
including short, medium and long govern-
ment bond funds (most focusing on eurozone
bond issues), inflation-linked gilts and corpo-
rate bonds. Here, too, investors are able to drill
down to refine their investments, for example
iShares offers the iBoxx £ Corporate Bond ex
Financials ETF, which might be attractive to
anyone wary of the outlook for banks in the
light of the UK's fragile economic recovery
and wanting to exclude them from a basket of
investment-grade UK bonds.
Currencies
Currency ETFs have been around for
about four years, and have proved
very popular during the bear mar-
ket. They track currency indices
that aim to reflect movements in
exchange rates between two currencies and
exposure to local interest rates. They are
swap-based products, backed by collateral
for safety, in effect guaranteeing investors the
return from exposure to specific currency
movements without having to hold or trade
any foreign exchange. There’s no need to hold
a currency account and there are no futures
or forward contracts, so they
are a relatively simple way for
more sophisticated investors
“It is possible to
looking for portfolio diversifi- buy longer-dated
cation to play currency mar-
kets tactically. But they’re not commodities
for novices.
The global currency ETF
that give less
market is dominated by US-
based Rydex and Powershares.
volatility and
However, ETF Securities a longer-term
entered the UK market at the
perspective”
end of 2009 with 18 currency
ETCs categorised as exchange
traded commodities on the
Scott Thompson
London Stock Exchange. These provide long
or short passive exposure to G10 currencies,
(including the Australian dollar, Swiss franc,
euro, sterling and yen), against the dollar.
Funds that are long the US dollar and short
a G10 currency, especially the euro, have
attracted most interest. The Short EUR Long
USD fund accounts for 50 per cent of inflows
to date in 2010 and the Australian dollar was
most popular as a long position.
Commodities
Only ETFs tracking the spot price of pre-
cious metals such as gold, silver, plati-
num and palladium can hold physical
assets. But these funds, especially
physical gold, have proved extremely
popular over the past year as investors have
looked to traditional safe havens in the face of
stock market volatility and dollar weakness.
ETF Securities now holds around $9 billion
in precious metals, according to co-head of
European sales Scott Thompson, including
‘more gold than the UK government’.
Other hard commodities are not practi-
cal to store (oil and gas for
instance), while agricultural
products tend to decay over
time, so these markets are
tracked via the Dow Jones/
UBS futures indices.
It’s possible to follow a sin-
gle commodity such as corn
or cotton, but Thompson says
many people prefer to diver-
sify with a wide agricultural
‘basket’ or take a macro view
with a mixed commodities
ETF, as they don’t have the
expertise to call individual
markets and these broad-based products are
less volatile than the individual commod-
ity funds. The main areas of interest, apart
from gold, have been in oil and gas (although
within quite a limited price range, with trad-
ers switching to short positions as the price
reaches $80-85 a barrel), and agriculture.
‘Investors generally go for the “front-
month” futures product that tracks expected
short-term price movements, but it is possible
to buy longer-dated commodities products
that give a bit less volatility and a slightly
longer-term perspective,’ Thompson explains.
It’s also possible to hedge against price falls
by using short commodity ETFs, and increase
your exposure via leveraged commodity ETFs.
Both are available through ETF Securities.

8 Money Observer ◗ Exchange Traded Funds ◗ May 2010

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Complex
funds for
the savvy
Leveraged and short ETF products
are not for the faint-hearted and
traps await the unwary

F
or active traders wanting to
manage their position in the
markets effectively, leveraged
and short exchange traded
funds are among the options on
offer. Unsurprisingly, interest
in their use has risen sharply
over the past year as investors have sought
to capitalise on the market recovery – and
Scott Thompson, co-head of European sales
at ETF Securities, anticipates that demand
is likely to continue this year in the current
uncertain market, as
investors look for the
return they need from
occasional short-term
opportunities.
So how do they
work, and what are
their strengths? A
leveraged ETF tracks
an index like any other,
but uses borrowed
money as well as your
capital, with the aim
of increasing returns. ETF Securities runs a
‘2x’ leveraged product, which means that if
you put in £1 it’s matched by £1 of borrowed
money; then, for every 1 per cent of FTSE
gain (or loss) in a day, your investment gains
(or loses) 2 per cent. The ETFS leveraged
products (unlike other leveraged ETFs) are
based on a specially created leveraged index,
which includes the interest costs of the
borrowed money as a single package to make
comparisons easier.
It’s important to recognise that in the
longer run your leveraged ETF may not match
double the annual return or loss of the index
it tracks, because returns are calculated on a
daily basis. It could be greater or less than an
annual return. This is because the products
deliver the daily percentage change, so
returns over longer periods are based on the
compounding of the daily returns. It is what
the industry calls a 'path dependent' product.
When the market is rising, more is
invested by the ETF each day to keep the 2x
leverage constant. However, when it is falling,
the opposite happens – the investment is
reduced each day.
“Leveraged As a consequence,
although you are
ETFs work receiving 2x leverage
on the upside, you
well in strong cannot lose more than
your entire initial
directional investment.
markets” ‘This is one major
strength of leveraged
Scott Thompson ETFs over other
leveraged products
such as futures or
options, where there is no cap on losses
and the higher levels of gearing available
mean you could lose two or three times your
initial investment,’ comments Thompson.
Nonetheless, they are clearly inherently more
risky than unleveraged positions, because the
leverage increases the volatility, and are not
designed for long-term buy and hold investors,
or indeed for anyone not actively monitoring
the market, either up or down.
‘They work very well in strongly directional
markets such as the strong rally from March to
May last year: traders put stop losses in place
so that they could get out in a timely fashion,’
Thompson explains. Equally, it’s possible to
get 2x short exposure through an ETF when
you’re convinced the market is heading south.
Short or inverse ETFs are also used by
active traders on a relatively short-term basis,
either to hedge a position in their portfolio or
to speculate on the likelihood that a particular
market is going to fall.
These are swap-based vehicles (see page
10) that produce a return guaranteed to mirror
the performance of the market benchmark
– which might be based in equities, property,
commodities or fixed income (there’s plenty of
choice). However, unlike conventional ETFs,
they correlate inversely with that performance
– hence the name. So if the benchmark index
rises, the ETF falls, and vice versa.
As with leveraged ETFs, one big attraction
of short ETFs over short investments involving
margin commitments is that, although there
is no limit to the potential for loss on a short
sale because the underlying asset price could
in theory rise indefinitely, losses are limited
to the original capital invested. In addition,
as Thompson emphasises, short ETF s can
be used to gain directional access to a range
of asset classes, and there are no margin
requirements that restrict their use.
But both leveraged and short ETFs are
designed for sophisticated, active investors
who understand the risks involved and are
ready to manage their positions. The potential
risks for unsuitable users were sufficiently
alarming for the Share Centre to withdraw
short and leveraged products last year, over
concerns that some investors buying them
didn’t fully understand their complexity.

Money Observer ◗ Exchange Traded Funds ◗ May 2010 9

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NUTS & BOLTS

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Building
blocks
We get under the bonnet of exchange traded funds
and explain the fees you are likely to pay, their different
structures, and any risks involved

M
ost ETFs are
not particularly
complex
investments; they
amount to a kind of
hybrid combining
the strengths of
index tracker funds and traded shares. Like
an ordinary index tracker fund, they aim
to replicate as closely as possible the index
following a particular market or sector.
But unlike tracker funds, they are bought
and sold on the stock exchange, in the same
way as a single company share is. So in other
words, you’re buying the performance and
diversification of an entire market in a single
package.
The range of market indices now
accessible through ETFs is enormous, and
continues to expand. In most cases, the
market indices are created by independent
index providers such as FTSE International
(FTSE), Standard & Poor's (S&P) and Morgan
Stanley Capital International (MSCI). For
some more esoteric products – for instance
certain ‘style-based’ ETFs – providers may
make their own indices by filtering down an
existing index.
As Nizam Hamid, head of sales strategy
at iShares, explains, index providers create
their own sets of requirements to define an
index universe. ‘For fixed income ETFs, they
build indices around criteria such as credit
quality and maturity,’ he says. For equity
ETFs, indices may be constructed on the
basis of market capitalisation, theme, sector
or geographical region.
Thus, it’s possible to buy equity ETFs
for single countries such as South Africa or
Turkey; regions such as Pacific ex Japan;
small or large caps within specific countries
or regions; market sectors such as banks or
basic resources; and ‘themes/styles’ such as
global infrastructure, value investments and
clean energy. Other options include ETFs
of commodities such as corn, iron and zinc;
currencies, and bonds and gilts.
For investors, the attractions of these
funds hinge on several key considerations.
First, as we’ve seen, they provide instant
diversification, and a manageable building-
block means of putting together a truly global
portfolio.
They can also be a simple, low-cost way
of getting exposure to more esoteric and less
accessible markets that are not otherwise
available in ‘pure’ form to retail investors. For
instance, ETFs tracking the Brazilian stock
market have been very popular recently on
“ETFs are
transparent
– you can
trade minute
by minute”
Graham Spooner
the back of the country’s thriving economy;
the nearest unit trust or Oeic equivalent
would be a Bric or Latin American fund.
Second, they are easily dealt and liquid.
They can be traded at any time of day in the
same way as a share; if you already have a
sharedealing platform in place, this makes
the whole process very quick.
As Graham Spooner, investment adviser at
broker The Share Centre, explains: ‘It’s also
transparent, in that you can trade minute by
minute at the price you see. With a unit trust
trading takes place once a day – if you have
to wait until the next day for your trade to go
through, the price may have moved.’
That’s not a serious consideration for
buy-and-hold investors, but it does open
the door to more active traders who want,
for example, to take a short-term position in
a particular market suffering a temporary
setback and likely to recover in the coming
hours or days.
COST control
Third, ETFs have very low running costs
compared to funds, because no active
manager is involved.
According to iShares, the average total
expense ratio (TER) of a bond ETF is 0.25
per cent, and for an equity ETF it’s 0.32 per
cent. Even the standard index tracker funds
available through the retail market have
average TERs of 0.8-0.9 per cent, according
to Investment Management Association
figures, while TERs for actively managed UK
equity funds are around 1.5-2 per cent. Nor
are there any incidental charges to rack up
along the way – stamp duty is not payable on
ETFs, unlike shares.
However, ETFs do come with some health
warnings attached. For a start, you need to take
into account the costs of dealing. Through an
online broker you should be able to carry out
execution-only trades for around £10 to £15.
On a £20,000 trade, £15 makes no perceptible
difference, but a £15 dealing fee on a £500
trade amounts to an extra cost of 3 per cent.

10 Money Observer ◗ Exchange Traded Funds ◗ May 2010

 Another factor that investors should be
aware of is that not all ETFs work in the
same way. Some, referred to as cash-based
funds, do buy all of the securities in the
underlying index and hold them as fund
assets – a process known as full replication.
But for some cash-based ETFs it may not be
practical to hold every single constituent of
the index. In these cases the ETF provider
takes a representative sample
of the index constituents and “Assess all
tracks their performance. Thus,
the iShares MSCI World ETF ETF products
holds only 700 securities of the
1,800 in the index itself.
and structures
index mimics
as each is
Some ETFs do not hold physical unique”
assets at all, but instead use totalNizam Hamid
return index swaps to mimic
the performance of the index in question.
This means that the ETF provider holds
other assets as collateral and enters into
a swap arrangement with another party,
to swap the return on that portfolio with
the return on the index to be tracked. In
effect, says iShares, investors are ‘buying the
performance of the index, not the physical
securities it contains'.
Swap-based ETFs can be more tax-
efficient in some cases, and are also useful
Visit MoneyObserver.com to view a range of
interviews where editor Andrew Pitts questions
leading fund managers and industry experts to
gain an insight into their views on the major
markets and sectors and to understand how they
Mark Mobius
manage their funds to gain top performance.
These fascinating insights are freely available
to all Money Observer readers.
Visit www.moneyobserver.com and see for yourself
Money Observer ◗ Exchange Traded Funds ◗ May 2010
when it comes to less easily accessed markets
such as commodities. They can also reduce
tracking error – the (usually) small but
inevitable underperformance of any index
tracking fund relative to the index itself –
because the full index return is guaranteed by
the counterparty to the swap.
Against this, swap-based funds are less
transparent than cash-based equivalents
because they don’t actually
hold the physical securities
of the index. Moreover,
there is the added risk that
the counterparty may fail
to honour its obligations,
although for funds marketed
within the EU measures
have been taken to limit the
counterparty risk involved.
‘It is important to assess all
ETF products and their structures (physical or
swap) when making an investment decision,
as each has its own unique exposure, risk and
tax implications,’ warns Nizam Hamid.
The bottom line is that with ETFs, as with
any other type of investment, you need to
take the trouble to understand the rudiments
of what you’re actually buying, how they fit in
with the other elements of your portfolio, and
where the potential hazards lie. Then you’re
ready to go.
Bruce Stout
Income Roundtable
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PORTFOLIO STRATEGY

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Core and
satellite of
your world
By using ETFs alongside some actively managed
funds you can invest in the more inaccessible
European and emerging markets and gain easy
entry to alternative asset classes as well

O
ne of the beauties of allocators first and foremost, so we take the He explains: ‘It’s easy enough in the UK
ETFs is that they offer view that most returns come from being in – we use FTSE 100 and FTSE 250 ETFs,
such a broad spectrum the market rather than from being invested which we reckon give a slightly better return
of access – at the one with a particular fund,’ he explains. ETFs combined than the FTSE All-Share; and if
end, full participation provide a low-cost route in, and, importantly, we were currently investing in the US I’d be
(or its equivalent) in a they remove the risks involved in trying to happy to use the S&P 500. The same goes for
regional or even world predict which manager will outperform the Japan and the Far East – there’s a clear-cut
index; at the other, the ability to drill down to market on a risk-adjusted basis. choice of ETFs from iShares.’ (Gough sticks
extremely niche markets that other types of But Gough is not a slave to the tracker with this range because they are cash-based
investment fail to reach. approach. He uses ETFs as a default position, and work best for wrappers such as offshore
As we’ll see, financial planners, especially which basically means wherever it’s the bonds.)
those with a strong asset allocation bias, most effective way of getting risk-adjusted However, he continues, Europe is a
make use of that flexibility in a number of exposure. Where he doesn’t feel comfortable different matter because there are so many
strategic ways within client portfolios. There in selecting an ETF for one reason or another, country/sector/market cap indices and
are various nuances, but on the whole, they he uses an actively managed fund. ETFs to choose from. ‘It’s arguably less
tend to be employed in one of two key roles.
First, they may be employed as a low-
cost core holding in some or all of the main ETHICAL ISSUES
markets, particularly in the UK and US
where active managers tend to struggle to Anna Sofat makes or arms manufactur-
beat the benchmark consistently. In this role the interesting point ers, for instance.
they tend to be in competition with index
trackers – which can in many cases work out
that she has used
swap-based ETFs (see
‘We had no way
of filtering collectives
Anna Sofat
marginally cheaper.
Second, they can be used to plug specific
page 10) for clients
with ethical concerns,
and individual shares
presented too high
uses swap-
market gaps – commodities, themes, single who wanted to buy a risk,’ she explains. based ETFs
countries – where index trackers are not
available; in some cases they may be chosen
into international mar-
kets including the Far
‘This way, they ben-
efited from any over- for clients
as an alternative to actively managed funds. East, China and Brazil,
but didn’t want to put
all uplift in the market
but didn’t actively
with ethical
Passive/active relative risks
One approach is that followed by Richard
their money into cer-
tain industries within
support the unac-
ceptable elements
concerns
Gough, a financial planner and director it – tobacco companies within it.’ Anna Sofat
at Castle Court Consultants. ‘We’re asset

12 Money Observer ◗ Exchange Traded Funds ◗ May 2010

risky to appoint an active
European equity fund
manager, so that is what
we do, on the basis of
factors such as consistency
of performance, ratings and experience.’
For emerging markets, too, Gough uses an
actively managed fund, this time alongside
an ETF.
Commodities are another area for
active management, though on different
grounds. ‘With a commodity ETF, you can
make a call on a specific commodity price,
and that’s speculation rather
than investment. But blended
commodity funds tend to be
“With a
very bland so we don’t bother
with them.’ Any fixed-interest
commodity
allocation, perhaps surprisingly, isETF you can
also actively managed, but
with strategic bond funds that make a call
enable the manager to move
across the bond and gilt
on a price”
spectrum as necessary. ‘It’s a Richard Gough
very fluid and strategic market,’
comments Gough.
Inaccessible investments
Alan Dick, managing director of FortyTwo
Wealth Management, takes a similar tack,
taking broad market positions and using
passive investments for the entire portfolio,
‘except where there’s no way to achieve what
we want’.
However, Dick
makes his choice from
both index tracker funds and
ETFs, selecting on the basis of both
cost and reliability. Currently the bias is
towards trackers. ‘At the moment some of the
institutional funds, for instance some L&G
trackers, are cheaper, so we’re tending to use
ETFs only in those markets where a suitable
fund isn’t available.’
So, for example, he is able to access
emerging markets using a Dimensional
tracker. In this case he prefers it to the
iShares MSCI emerging markets
ETF, partly because the latter
contains ‘lots of stuff – in Russia
and elsewhere – that you wouldn’t
want to touch with a barge
pole’. The Dimensional fund, in
contrast, uses a screening process
to create a more desirable index.
As a consequence, at the
moment only two ETFs currently
feature in his portfolio – both for
property coverage, which is not
offered through index trackers. ‘We’re using
the iShares FTSE/EPRA Developed Market
Property Yield and UK Property ETFs,’ says
Dick. The choice of which one to include in
a portfolio is based on tax considerations.
He prefers the idea of global diversification
available from the former – but it is a ‘non-
distributor’ fund, which means gains are
taxed as income at up to 50 per cent,
Money Observer ◗ Exchange Traded Funds ◗ May 2010
so he only utilises it
within a tax wrapper such
as a pension or Isa. In
contrast, the UK fund has
distributor status, so that
gains are taxed as capital
gains at only 18 per cent.
Core/satellite
Rebecca Taylor, managing director of
Dunham Financial Services, is another
financial planner with a passive investment
bias. She uses ETFs for the core long-term
holdings of most clients, on the grounds
that active managers rarely beat the market
over that time frame. That includes Europe,
despite the plethora of ETF offerings
available. ‘It’s a complex area, so we need
to be quite specific; we use a broad spectrum
of holdings to mimic the main markets,’
she says.
Smaller ‘satellite’ holdings tend to be
alternative assets that add diversification –
and it’s here that she’s prepared to accept
more variety in the type of investment vehicle
selected, depending on what’s available.
‘We may include active funds – for example,
we use the EEA Life Settlements fund and
JPMorgan’s Natural Resources fund, and
we also use an active fund manager for
hedge funds. But there are other alternative
investments that happen to be easy to access
via ETFs, such as property, gold and private
equity,’ she adds.
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DIPPING INTO ESOTERIC MARKETS

While asset alloca-
tors may use ETFs
mimicking the broader indi-
ces to gain the kind of core
regional exposure they need
at low cost, there is also an
argument for dipping into
the wide and rapidly grow-
ing range of more esoteric
ETFs available, in order to
access specific interest-
ing single country, style,
thematic or commodity
markets.
Brazil, Korea and China; the
physical gold ETF has also
been extremely popular.’
Such markets are not
generally tracked by index
trackers and so would be
quite difficult to access oth-
erwise for those who simply
want to tap into the growth
trend rather than commit-
ting themselves to the value
judgements of a particular
active manager. ETFs lend
themselves well, because
they provide exposure to the
whole market, and are easily
bought and sold at close to
net asset value.
As John Lang, manag-
ing director of IFA Tower
Hill Associates, observes:
‘They’re a great tool for
“detailed granularity”, if you
want to home in on the mar-
ket growth in a specific sec-
tor, commodity or country.’

“We have seen

‘Drilling down’ in this
way tends to be favoured
by more active or sophis-
ticated investors who may
a lot of inflow over
take relatively short-term
or medium-term positions
the past year into
in their chosen assets. For specific emerging
example, says Nizam Hamid
at iShares: ‘We have seen countries”
a lot of inflow over the past Nizam Hamid
year into specific emerging
market countries, including

Mature markets could easily rebalance your allocations.’ monitoring the market on a close basis. But
Even IFAs who generally favour actively Stuart Fowler, managing director of IFA there may be occasions when a relatively
managed funds as the basis of client firm No Monkey Business, is one such adviser. short-term position is justified for clients,
portfolios may justify the use of ETFs for ‘For long-term equity holdings that are as Anna Sofat, managing director of Addidi
certain core markets – basically those that unlikely to be touched for 20 years plus, we Wealth, explains.
are so thoroughly researched and accessible buy institutional tracker funds because they ‘Last year, when the FTSE was down to
that active fund managers find it hard to add are the cheapest option,’ he explains. ‘But the around 4000 and interest rates had fallen to
much value. rebalancing stock is held in ETFs on a broker nothing, there was a big question for some
As Darius McDermott, managing director platform. As individual markets move against clients over what to do with their money.
of Chelsea Financial Services and a firm each other, our weightings change. There’s We put some of them into a FTSE All-Share
believer in the long-term advantages of the no “fixed mix”, but we can make all our ETF, because we knew that it had to go up
best actively managed funds, explains: ‘I would adjustments very easily via ETFs.’ over the coming months, but there was the
consider using ETFs in areas such as the US understanding that we would keep an eye
large cap market, where it’s very difficult Short-term tactical holdings on it and pull out when it became necessary.’
to identify active fund managers that are Financial advisers and planners are looking This was intended as a short-term move,
consistently able to outperform the market.’ at long-term strategy and therefore tend to adds Sofat, but in the event one client has left
leave tactical dodging and weaving to the her cash invested, drawing profits from time
Annual rebalancing day traders and active investors who are to time as an income stream.
Some financial advisers and planners are
attracted by ETFs’ advantages of liquidity
and simplicity of trading, utilising them Contacts
as a fluctuating buffer zone around a core
Providers Background information Yellowtail Financial
holding of long-term funds (active or passive) Planning
invested in the same assets. Because ETFs are ETF Securities Morningstar
020 7448 4330, www.morningstar.com 020 7933 8671,
so easy to trade on the stock exchange, any www.yellowtail.co.uk
www.etfsecurities.com LSE www.londonstockex-
rebalancing necessary to the portfolio can be No Monkey Business
done through them, rather than by buying or iShares 0845 357 7000, change.com
www.uk.ishares.com 020 7736 2434,
selling the funds themselves. IFAs/brokers www.nomonkey
Nizam Hamid, head of sales strategy db-x 020 7547 1747, Selftrade 0845 070 0720, business.co.uk
for iShares, gives an example. ‘If you had a www.dbxtrackers.co.uk www.selftrade.co.uk Addidi Wealth
particular asset class accounting for a chunk of Lyxor www.lyxor.com Tower Hill Associates Management
your portfolio, you could work out how much Powershares www.inve- 0208 891 6375, 020 7060 1200,
it was likely to move over the longer term, scopowershares.com www.towerhillassociates.com www.addidi.com
and then hold that margin in ETFs so that you

14 Money Observer ◗ Exchange Traded Funds ◗ May 2010