ETFs explained ADVISORY. Member of the London Stock Exchange

Transcription

1 ETFs explained ADVISORY ADVISORY Member of the London Stock Exchange

2 Killik & Co Killik & Co is a financial services firm with a stock broking heritage offering financial and securities advice and execution as well as investment management across the whole market. We are an independently owned business and we are not tied to any particular product providers, so we can consider the widest range of investment options for our clients needs. Under the Retail Distribution Review (RDR) our regulator has chosen to define life policies, pensions, unit trusts, open ended investment companies (OEICS), investment trusts, and Exchange Traded Funds (ETFs) as Retail Investment Products (RIPs). For an adviser to be able to refer to themselves as independent they have to be able to advise on all RIPs. Our Brokers offer specialist investment advice which includes advice on unit trusts, OEICS, investment trusts and ETFs. However, under this definition, as they do not offer advice on life policies and pensions theirs is deemed to be restricted advice. Our Wealth Planning division (Killik Chartered Financial Planners) offer holistic financial planning advice that can include all RIPs, so their advice is deemed independent advice. However, where our Wealth Planners identify an investment need you may wish to talk to one of our Brokers as they have greater investment expertise and can cover all investment types (including equities, bonds and derivatives), not just RIPs We pride ourselves in being a relationship firm. Each client has a single point of contact, be it a Broker or Wealth Planner to provide award winning advice and trade execution, as well as handling any administrative matters. We also provide our clients with independent research, from our team of analysts, who are frequently quoted in the press along with our Daily Note by and our quarterly magazine Confidant. Killik & Co, your partner for investment and wealth advice. Contents 3 Introduction 4 What are ETFs? 5 Why invest in ETFs? 6 Physical replication versus Swap based 7 ETF share creation 8 Counterparty risk 9-11 What to look out for in an ETF 12 The London-listed ETF market 13 ETFs main risks 14 Killik & Co s view on ETFs Killik & Co ETFs explained 02

3 Introduction Exchange Traded Funds (ETFs) are receiving more and more attention from investors. Their transparency, low charging structure and the ease with which they can be traded have big appeal. They are particularly attractive to private investors who can now easily and cost effectively access a range of assets as diverse as Chinese equities, Emerging Market bonds, gold bullion and sugar futures. Also, most London-listed ETFs are stamp duty exempt and eligible to be held in ISAs and SIPPs. First introduced in the US in 1993 the exchange traded product market has grown rapidly with assets under management globally exceeding $1.5trn. The asset classes covered range from equity and fixed interest to commodity, currency and even hedge fund strategies. Killik & Co ETFs explained 03

4 What are ETFs? Buying an ETF is equivalent to buying an index in a share. That is because ETFs have only one investment objective to track the returns of a specified index, after fees. For example, the ishares FTSE 100 ETF aims to deliver the return of the FTSE 100 Total Return Index, less annual fees of 0.4%. Structure-wise, ETFs are a hybrid between open-ended and closed-ended funds. They are open-ended in that the number of shares in issue expands and contracts as investors buy more shares than are being sold (leading to net creations) or sell more shares than are being bought (leading to net redemptions) respectively. Just like closed-ended funds, ETFs are exchange listed and traded securities (hence the name Exchange Traded Funds), meaning that an investor can purchase/sell them anytime during the trading day, just as they would do with a share. Unlike closed-ended funds however, where the shares can sometimes trade at a substantial premium or discount to the NAV (net asset value, the value of the fund s underlying assets), ETFs normally trade within a close range of their NAV, as any excess demand/supply can be satisfied by new share issuance/redemptions. Killik & Co ETFs explained 04

5 Why invest in ETFs? There are a number of reasons why an investor would buy an ETF. An actively managed fund giving exposure to a specific market may not be available Turkish equities for example, or the spot price of gold. An investor may believe that the actively managed funds available are unlikely to outperform the index and hence the ETF. An investor may wish to establish quick exposure to a market while they take time to identify actively managed funds or stocks to invest in. Establish a core-satellite strategy, where the ETF forms the core and stocks and/or actively managed funds and/or other ETFs are the satellites. Tracking error Tracking error is the level by which the ETF net asset value return deviates from the index return. Most ETFs will underperform the index tracked by at least the amount of the fees the ETF provider charges. However, increased competition means that ETF providers are constantly looking for ways to minimise the tracking error. Killik & Co ETFs explained 05

6 Physical replication versus Swap based While all ETFs have the same objective, to track an index as closely as possible, the way they achieve this objective can vary. Most ETFs achieve their investment objective either by physical replication (buying all, or a representative basket of the index constituents) or via swap contracts. A swap contract is a contract where two parties (in this case the ETF and a financial institution, generally an investment bank) agree to swap a series of returns. For example, the db x-trackers FTSE 100 ETF holds a portfolio of securities, which may be completely different to the FTSE 100 index, and agrees with a bank to swap the returns of this portfolio for the returns of the FTSE 100 index. At regular intervals payments will be made between the two parties so that the value of each portfolio reflects the return sought. This means that in effect, although the ETF holds securities other than those of the index tracked, the ETF value will reflect the returns of the index tracked, in this case the FTSE 100 index. While achieving returns via swap contracts makes such ETFs, to some extent, a less straightforward investment, there are benefits to this strategy. Most importantly, this strategy makes possible the existence of ETFs tracking indices with a low level of investability, such as a commodity futures index for example. Another benefit is the fact that the tracking error outside that attributable to the ETF fees is eliminated. A physical replication strategy is likely to experience such tracking error, especially if a representative portfolio is held rather than all the index constituents (it is normally impractical and uneconomical to hold all the constituents of a large index, such as the MSCI World for example, which aggregates the performance of over 1,000 companies). With a swap return however, the precise return to the index is delivered to the ETF by the counterparty. Killik & Co ETFs explained 06

7 ETF share creation Physical replication ETFs Investor (via Broker) Cash FTSE 100 ETF shares Market Maker Buy FTSE 100 constituents in the market in corresponding market weightings (or may already hold on their books) and deliver to ETF custodian Issue FTSE 100 ETF shares ETF Custodian Swap based ETFs Investor (via broker) Cash FTSE 100 ETF shares Market Maker Buy securities as agreed with swap counterparty (can be completely different from the index underlying holdings) and deliver to ETF custodian Issue FTSE 100 ETF shares ETF Custodian Flow of funds reflecting the difference between the returns of portfolio held at custodian and the index return Swap counterparty Killik & Co ETFs explained 07

8 Counterparty risk One of the biggest drawbacks of swap based ETFs is the counterparty risk that comes with them. Because their returns are delivered by a counterparty, the ETF holders run the risk that the counterparty will not deliver on its obligations. In order to mitigate this risk some ETFs have collateral in place, which means that if the counterparty were to default, the collateral could be sold and the proceeds returned to the ETF holders. However, because in most cases the collateral is not representative of the index tracked, it cannot be guaranteed that the collateral proceeds will cover 100% of the ETF net asset value. Furthermore, if an alternative vehicle offering the same exposure is not available, investors will also be faced with re-investment risk. Killik & Co ETFs explained 08

9 What to look out for in an ETF The index tracked There can be a variety of indices for the same market, so it is important to understand which index a certain ETF is tracking. For example, whether the index is a price index or a total return index (taking account of income), whether it is market weighted/equally weighted or weighted in a different manner, whether it is a capped index (the weighting of some of the index constituents is capped), whether it is a spot price index or a futures index (generally for commodity ETFs). Futures prices versus spot prices Futures price returns can be quite different to spot price returns. That is because futures contracts have a limited life, which means that at expiry, in order to maintain exposure to the underlying asset or index, investors need to sell the expiring contract and buy a contract of a later maturity. The difference between the price an expiring contract is sold and the new, later maturity contract is bought is called the roll yield. The roll yield would therefore add or subtract from the spot price return. Most commodity ETFs (also known as Exchange Traded Commodities, or ETCs) track indices based on futures prices. That is because holding most commodities in physical form would incur significant storage and insurance costs plus, some commodities, such as grains, are perishable. The Total Expense Ratio (TER) Also known as Annual Management Charge (AMC), this is the annual fee the ETF provider takes for its services in running the ETF. Generally it ranges from 0.2% to 1% and it normally accounts for most of the tracking error (all of the tracking error in the case of swap based ETFs). Physical replication or Swap based If physical based, generally the more illiquid the index constituents and/or the higher their number, the harder it will be for the ETF manager to minimise tracking error. If swap based, investors should assess the credit-worthiness of the counterparty and the level and composition of the collateral in place. Killik & Co ETFs explained 09

10 Stock lending practices ETF providers are continually looking for ways to minimise tracking error. One way physical replication ETF providers can generate additional income and offset some, or all, of the TER is stock lending. Stock lending, however, carries counterparty risk and therefore it is important to know the extent of the stock lending practices and what collateral, if any, is in place. Liquidity The liquidity of an ETF should be the same as the liquidity of the underlying index components. That is because if an investor wishes to buy an ETF and there are not sufficient sellers in the market, the ETF would create the necessary shares by purchasing the underlying index components. Leveraged and Inverse/Short ETFs When considering such ETFs, it is important to know the period over which the index returns are compounded. Most leveraged and inverse ETFs compound returns daily. For example, an inverse/short (-1x) daily compounded ETF on a particular day would provide investors with -1x the daily return of the index. It is important to understand however that over periods longer than a day the return of the ETF can be significantly different from the return of the index times the multiplying factor (in this case -1x). Furthermore, investors should be aware that should the index rise by 100% or more in one day an inverse (-1x) ETF would lose all its value, while a 2x leveraged ETF would become worthless if the index were to fall by 50% or more in one day. Generally, the more volatile the underlying index, the bigger will be the divergence between the inverse/leveraged ETF return over a certain period and the index return times the multiplying factor see illustration opposite. Killik & Co ETFs explained 10

11 Index low volatility Day 1 Day 2 Day 3 Day 4 Index Daily Change 1% 1% 1% Cumulative change 1% 2% 3% Leveraged ETF (+2x) Daily Change 2% 2% 2% Cumulative change 2% 4% 6% 2x index cumulative change Inverse/Short ETF (-1x) Daily Change -1% -1% -1% Cumulative change -1% -2% -3% -1x index cumulative change Index high volatility Day 1 Day 2 Day 3 Day 4 Index Daily Change 25% -28% 14% Cumulative change 25% -10% 3% Leveraged ETF (+2x) Daily Change 50% -56% 29% Cumulative change 50% -34% -15% -5x index cumulative change Inverse/Short ETF (-1x) Daily Change -25% 28% -14% Cumulative change -25% -4% -18% -6x index cumulative change Fund or note? Most exchange listed trackers are set up as UCITS OEICs. These tend to track equity or fixed interest indices. However, in a bid to make new asset classes available via trackers, such as commodities and currencies, some providers have issued exchange traded notes (ETNs). As they are not funds, their issuers refer to them as ETCs (Exchange Traded Commodities or Exchange Traded Currencies). However, most investors loosely refer to them as ETFs, given that, in essence, they have the same return objective as ETFs. Because these notes are normally issued by a financial services firm, just as with swap based ETFs, investors need to consider counterparty risk and the level and quality of the collateral, if any. Killik & Co ETFs explained 11

12 The London-listed ETF market There are currently over 1,000 listings on the Main Market of the London Stock Exchange from seventeen ETF/ETC providers. These cover a variety of asset classes, from equity and fixed interest to commodities and currencies. The biggest issuers are ishares, ETF Securities, db xtrackers and Lyxor ETF. Most of them are eligible for inclusion in SIPPs and ISAs. Killik & Co ETFs explained 12

13 ETFs main risks Tracking error in excess of the TER it is possible that physical replication strategies fail to match the index returns less fees. Counterparty defaulting if no collateral is in place, the ETF holders can potentially lose all their investment. If collateral is in place, it is possible that the proceeds from the collateral sale are short of the net asset value of the ETF. Even if investors do receive the whole value of the NAV, they may then face re-investment risk, i.e. not finding an alternative way to maintain exposure to the index in question. Wide bid-ask spreads it is possible that some ETFs may trade at wide bid-ask spreads at certain times. This is more likely if the underlying index constituents are trading on wide bid-ask spreads, or if markets are experiencing high levels of volatility. Killik & Co ETFs explained 13

14 Killik & Co s view on ETFs While we firmly believe that a skilled active manager should outperform the market they invest in over the longer term, we believe that ETFs are a useful addition to the investment universe and that there are times and situations where an ETF may be the best investment option. More information We publish a monthly ETF Bulletin providing details on the entire London-listed ETF range. The information includes legal structure, counterparties, TERs, typical bid-offer spreads and performance data. For a copy of the bulletin or for more information please contact your Broker. If you are new to Killik & Co, please call us on Want more? If you want to know more about ETFs please call Details of our fees and charges are available on our website. More info at: Killik & Co ETFs explained 14

15 Killik & Co 46 Grosvenor Street London W1K 3HN ETFs explained Killik & Co is a trading name of Killik & Co LLP, a limited liability partnership authorised and regulated by the Financial Conduct Authority and a member of the London Stock Exchange. Registered in England and Wales No OC Registered office: 46 Grosvenor Street, London W1K 3HN. A list of partners is available on request. Killik & Co (Middle East & Asia) is regulated by the DFSA. Telephone calls may be recorded for your own protection and quality control. The tax treatment of investments may change with future legislation. You should be aware that the value of investments and the income from them may vary and you may realise less than the sum invested. Fluctuations in currency exchange rates may have an adverse effect on the value of investments denominated in currencies other than sterling. Past performance of investments is not a guide to future performance. This financial promotion has been approved by Killik & Co.