More investors catching on to ETFs

Jun 21 2010 by Christine Hawdon, The Journal

SINCE their launch in the 90s, Exchange Traded Funds (ETFs) have opened new avenues of investment opportunities for investors. ETFs were initially used by institutional investors, but retail investors have been catching on quickly.

There has been substantial growth over the last 10 years and it is forecast to continue as investors diversify their assets into more exotic areas.

ETFs are essentially index tracking vehicles, but, unlike traditional tracker funds, they are listed on a stock exchange like shares and can be bought and sold throughout the trading day.

Exposure can be gained to a whole area of the market in a single trade through an ETF and the charges are typically lower than those of other forms of collective investments. The stockbroker’s commission rate applies but ETF purchases do not attract stamp duty.

ETFs can be constructed by providers in various ways. For example, if all of the securities in an index are bought this is known as direct replication.

The investor has the security of knowing that the ETF is backed by physical assets but its performance may not track the index definitively due to the costs associated with the replication process. Alternatively, if a security proves difficult to buy, the provider may use a derivative with a counterparty known as a “swap” to replicate the index rather than buying the underlying shares.

This practice is known as synthetic replication and can be advantageous because the ETF provider does not incur the transaction costs of buying the assets. However, an ETF using synthetic replication may be exposed to the risk that the counterparty may default.

To prevent this type of risk some providers use more than one counterparty or insist on holding collateral equivalent to or greater than the net asset value of the ETF.

ETFs could be used to gain exposure to core indices such as the FTSE 100, S&P 500, Hang Seng, or Nikkei.

Alternatively, a portfolio may be constructed using ordinary stocks and shares to create a foundation and ETFs or Exchange Traded Commodities (ETCs) could be added to provide exposure to exotic areas such as gold or other precious metals as well as other thematic investments like agriculture or infrastructure.

Although ETFs have a number of attractive benefits, we do recommend seeking professional advice before undertaking any type of investment to ensure it is suitable for your needs.

Christine Hawdon, Chartered FCSI christine.hawdon@brewin.co.uk