Five reasons for investing with ETFs

IT HAS not been an easy few weeks for exchange-traded products (ETP). First, analysts as good as wrote off physically backed industrial metal exchange-traded commodities (ETCs) before they had even been launched. And earlier this week, an American report from the Kauffman Foundation criticised ETPs, arguing they might pose a greater threat to the markets than high frequency trading.

Authors Harold Bradley and Robert E Litan point to the ease with which ETFs can be short-sold as well as the consequences of a short squeeze on ETFs. The industry is still digesting the report, which has already come in for a fair share of criticism.

European investors should remember that the ETP market this side of the pond is different to its American counterpart in size, structure, and complexity. Like any investment product, ETPs should be treated with their fair share of caution but they still offer investors plenty of advantages.

ETPs are listed on a stock exchange, which means they can be traded in the same way as a share and do not have the opacity of many over-the-counter products. For example, you get continuous pricing of an ETP and real-time execution means that you know the price you are paying for the product.

Many providers of physical ETFs now list all the securities that they hold and this is updated on a daily basis. Providers that have taken the synthetic approach have also increased their commitment to become more transparent: they are now clearer about what counterparty exposure owners of swap-based ETFs have and whether the ETF is fully collateralised or not.

ETFs are praised for their ability to give you more liquid exposure to illiquid markets. Providers argue that the real liquidity of an ETF is the liquidity that a market maker is available to provide given how liquid the underlying securities are.

While it is true that most ETFs in Europe are very liquid, such liquidity may be more difficult to find if Europe follows America down the route of increasingly specialised and esoteric products.

The Kauffman report warns “just because small cap companies that may individually be illiquid are wrapped up in an ETF, which itself becomes liquid, does not make those stocks liquid”.

Under Ucits III, European ETFs (excluding those from Switzerland) are subject to much more stringent diversification rules than their US counterparts. Ucits dictates that no individual constituent should represent more than 20 per cent of a fund’s net asset value, a figure that can be relaxed to 35 per cent at the regulator’s discretion.

Consequently, you will never be exposed to single-stock risk if you invest through an ETP and you get a more attractive balance of risk and return than if you invested in a concentrated portfolio. By spreading investments across various assets, the expected return can be achieved with less risk, according to BlackRock’s ETF division iShares.

For the average retail investor, it is difficult to gain exposure to the performance of stock markets on the other side of the world. However, ETPs can provide the building blocks of your portfolio, allowing you to allocate to the full range of asset classes including corporate bonds, property and single country indices tracking markets like Vietnam.

This allows you to create a portfolio with both core and more esoteric investments with ease. You can also choose between single country indices or regional indices to tailor your exposure.

One of the main attractions of ETPs is that they are cheaper than actively managed funds. On average, the average total expense ratio (TER) of an equity ETF is 0.4 per cent compared to 0.82 per cent for an index-tracking mutual fund and 1.77 per cent for an actively managed mutual fund, according to Morningstar data.

However, investors considering ETFs need to be aware that rebalancing costs and volatility can affect how accurately the ETF tracks the underlying index. Any difference between the two can be considered a cost.

Investors should also bear in mind that the transaction fees for buying and selling ETFs far outstrip the costs (if any) of funds. For example, Barclays Stockbrokers will charge frequent traders £6.95 per online trade while ETF trading costs at Hargreaves Lansdown start from £9.95.