An Exchange traded fund (ETF) is a fund that is designed to track the performance of a specific market or index as closely as possible, nothing more, nothing less.They have been available in the US since 1993 and in Europe since 1999.
ETFs allow investors to diversify over a wide range of markets, geographic sectors and asset classes. For example they may track the S&P500 in the US or the UK FTSE 100 as well as more obscure emerging market equity indexes. They can track indexes of fixed income investments, for example US Treasuries or European corporate bonds. They may also track the price or a specific asset or commodity, e.g. gold or oil.
There is no active management involved in ETFs and as a result, there is no manager to pay. This means that while the average (literally) managed fund charges around 1.5% per annum in management fees, an ETF will charge 0.25-0.5% per annum.
ETFs are traded like regular shares. They can be bought and sold at any time, with prices changing throughout the day. Like shares, they can also be sold short (i.e. a bet that the index value will decline).
Physical Versus Synthetic
There are 2 basic types of exchange traded fund, physical and synthetic. A physical ETF holds the actual assets that it tracks. For example if it tracks the price of gold, it will own physical bullion. If it tracks the FTSE100, it will own shares in the companies that comprise the index.
Synthetic ETFs are more complex than plain vanilla “physical” ETFs, as they are designed to track investments in securities which cannot be physically held, e.g. commodities such as oil, wheat, corn and pork bellies or more exotic emerging markets.
To do this, instead of owning the physical assets that it is designed to track, the ETF provider contracts with a third party (often an investment bank), which agrees to pay the difference between the value of the ETF’s assets and the assets or index it is designed to track, using a derivative known as a swap agreement.
The big question mark over synthetic ETFs is the status of this third party. What happens if that third party to the deal becomes bankrupt, defaults or simply does not meet its obligations?
Securities lending is another issue for ETFs. The practice of securities lending is an established and well regulated activity in the investment management industry. It involves the transfer of securities (such as shares or bonds) from a Lender (in this case, the ETF) to a third-party (the Borrower). The Borrower will give the Lender collateral (the Borrower’s pledge) in the form of shares, bonds or cash, and will also pay the Lender a fee. This fee provides additional income for the fund and thus can help to reduce the total cost of ownership of an ETF.
The risk lies in the fact that the collateral that has been provided by the Borrower may be of an inferior quality to the assets which it has borrowed.
Summary – Key Benefits
To summarize, when investing in ETFs a certain level of due diligence should be performed to make sure that the underlying assets that you are investing in are secure.
However, once this has been done, the benefits of using an ETF are as follows:
- Low costs
- Buying and selling flexibility
- Ease of diversification
[ETFs are particularly useful structures when combined with offshore insurance bonds (Skandia Executive Investment Bond, Friends Provident Reserve, Zurich Elite International Bond, Generali Professional Portfolio Bond) as they allow investors to diversify their portfolio in a simple and cost effective manner. If you have such a structure and would like to discuss whether ETFs would be suitable in your portfolio, contact us and we will arrange for a qualified financial adviser to get in touch with you.]