Investments

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.

Cash ISAs – Slash and Earn?

With interest rates at historically low levels, many cash ISAs are now paying unattractive rates of interest, often less than can be realised from a standard savings account.  As rates have been slashed by providers, do the benefits still stack up?

Cash ISAs give the opportunity to earn interest on cash without the interest being subject to tax.  Over time, individuals can build a substantial tax shelter by investing their full cash ISA allowance each year.  The allowance in 2009/2010 is £3600, with the curious addition of an extra £1500 allowance for anyone over 50, available from October 6th 2009.  Going forward, the allowance will rise to £5100 for all in 2010.

Until recently, a common gripe of cash ISA investors was that they could get an attractive rate, but only on their allowance for the current year.  Old cash ISA accounts would see their initial high rates fall away, and new accounts would not allow the transfer in of existing cash ISA funds.

The current situation is that cash ISA interest rates are historically low, but providers are again allowing transfers of existing ISAs into new accounts.

For higher-rate tax payers, they remain attractive – an interest rate of 2.5% on an ISA would beat a taxable rate of 4.16%.  For basic rate tax payers, a 2.5% ISA rate beats a  taxable rate of 3.2%.  And don’t forget, you may only be a promotion or two from becoming a higher rate tax payer, so it could make sense for you to squirrel that money away now, if you can afford to.

The best rates tend to go to those who have either the most money in their ISA or who are prepared to tie up their money for the longest amount of time, but good deals do arise – it is up to the savvy investor to keep abreast of new offers, determine what is best for them and move quickly to avoid disappointment.

Check with your bank or building society, or for the bigger picture, investigate comparison websites or the ‘best buy’ pages of the financial press.

Remember though, that what is a good deal at the time may not be so good later on.  Keep an eye on your rates if they are variable, and keep a weather-eye on the overall market.  Competition for investor’s cash breaks out between firms in March and April as they hustle for people using up the current tax year’s ISA allowance and investing quickly for the following tax year’s ISA allowance.  This is often a good time to snap up deals.

If you do decide to switch your cash ISA to another provider, remember to take careful note of the process.  Usually, your new provider will request a form completed with your old cash ISA details, and they will arrange the transfer for you.  If you take the cash out in order to pay it to another provider, you will lose the tax-free status of your cash.  Check with your new and current provider, and make sure you know the full rules by checking the HM Revenue & Customs website.

Pros – Tax-free shelter, ability to transfer funds between ISA providers (subject to individual terms and conditions), expected increase in allowance in future years.

Cons – Current low rates of interest, more paperwork than a standard savings account, convoluted process for transferring between providers, limit on investment.

Demerger / Spin-Off – Mandatory Corporate Action

A spin-off / demerger is when a company decided to break away part of its business into a new entity. There are various reasons why a company may do this. Multinational corporations may want to set up new brands within other countries. Generally it is a branding decision, in that a company may decide that the parent brand is not suitable for marketing a new product. Sometimes demergers follow takeovers for this reason. For example, a telecoms giant may takeover a smaller shortwave radio company, but then spin off the company again so that it can continue to operate with its old brand in tact. Possibly the most famous example of this in recent years was the Mannesmann-Vodafone merger and the spin off of Orange.

A spin-off is a new organization or entity formed by a split from a larger one, such as a new subsidiary company spin off from its parent company. The shares are issued under a specific ratio. Resulting shares are received under a new ISIN code and company name, shareholders will get to keep their existing ordinary shares and will receive new shares in the newly formed company.

Demerger is the converse of a merger or acquisition. It describes a form of restructure in which shareholders in the parent company gain direct ownership in a subsidiary (the demerged entity). Underlying ownership of the companies and/or trusts that formed part of the group does not change. The company or trust that ceases to own the entity is known as the demerging entity. If the parent company holds a majority stake in the demerged entity , the resulting company is referred to as the subsidiary.

As usual, if you hold share in a company and it announces a demerger, you should not be disadvantaged, as the resulting market value of the two individual stocks should equal the previous market value of the parent stock.