ETFs – Unbelievable!

OK, so it was EMF who had a hit with Unbelievable back in 1990 and OK, maybe it’s stretching the facts a bit to call Exchange Traded Funds (ETFs) unbelievable, but they do have some interesting properties and are now heavily used by the asset management industry.

Traditionally, investors who wanted exposure to a number of stocks in order to achieve a good level of diversity, would either have to invest a lot of money into direct holdings, or invest via a managed fund (a Unit Trust, Investment Trust or OEIC).

Typically, managed funds under-perform the market, especially after fees are taken into consideration. Certain fund managers have great track records, but anyone can have a bad year, managers can move to new investment houses, the management style of the fund may not chime with current market trends, and so on.

In addition, trading in Unit Trusts and OEICs tends to happen once a day, so you could ask to sell your holding at 2pm, but not actually be able to sell until the next dealing point at midday the following day, leaving you exposed to market risk in the meantime.

Investment Trusts trade on open markets, but they can trade at a premium or discount to the net asset value of their holdings, adding an extra element of risk.

The first answer to these problems was the launch of Index Tracker funds. These were a popular, low-cost method of gaining exposure to markets, but they were less than perfect. They could not perfectly track their chosen index- there was always a ‘tracking error’. They could also – like the managed funds already discussed – suffer from liquidity issues (if large amounts of investors want to sell at the same time, this could incur additional costs – known as a dilution levy). Typically structured as OEICs, they also had the trading issues discussed above.

The latest, and most effective, solution is Exchange Traded Funds. These trade on exchanges (like Investment Trusts) but are priced at their net asset value (like OEICs and Unit Trusts).

Asset managers turn to ETFs

The reason you should be excited about ETFs is that the professionals now use them in the products that they sell to wealthy individuals. Asset managers, who charge their clients large fees to invest with them, have realised that many of their existing products – where they would typically invest with fund managers (often in fund-of-fund or multi-manager structures) – just aren’t effective enough.

Their fund managers could not produce suitable returns after fees, and many have now turned to ETFs as a cheap way of getting exposure to markets.

Typically, they will have a core holding of ETFs, with smaller, ‘satellite’ holdings in more specialist areas (eg emerging markets or small companies) where they believe they can generate returns from individual fund managers.

The common theory among asset managers these days is that investment returns are best generated through asset allocation decisions, rather than the underlying holdings. This approach makes cheap access to markets combined with ease of trading highly desirable.  ETFs can also provide exposure to commodities such as gold and oil, as well as currencies, making investment in these areas far easier for the private investor than it has ever been before.

So, if you want exposure to a specific asset class, with flexibility and low costs, ETFs may be a good choice for you.

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