As the credit crisis crunches around the globe and eats away at the value of stock and bond portfolios, the truism of diversifying to reduce risk and volatility has never rung louder writes Tim Falconer.
Exchange Traded Funds, or ETFs, are one such investment vehicle that savvy family offices and investors are exploiting to protect, grow and hedge family investments against rollercoaster financial markets.
"In truth, diversification as a way of protecting wealth has always been important, it is just that for most of the last six years, it has not mattered if you have remained concentrated on just one asset," says Phil Collins, director of investment at Newton Private Investment Management.
"Recent market turbulence has refocused the minds of investors and highlighted the dangers of being overly concentrated on one asset," he adds.
Essentially, ETFs are open-end index funds that are listed and traded on exchanges. Like shares, they allow investors to gain broad exposure to entire stock markets of different countries, emerging markets, sectors, styles as well as fixed income and commodity indices with relative ease.
This can be done on a real-time basis and at a lower cost than many other forms of investing.
"The obvious benefit from a tax point of view for the UK investor is how the Inland Revenue now treats disposals in UK offshore funds distributor status funds. From the 6 April 2008, a flat rate of capital gains tax at 18 per cent applies to disposals of such funds. This is therefore very beneficial to high net worth individuals investing in the country," says John Fletcher, an ETF specialist broker at Charles Stanley Stockbrokers, based in London.
Investment Bank Morgan Stanley is also a big fan of ETFs and in a recent note to investors said it is essential to have core equity holdings, especially in today's environment of increased market volatility.
"Since no single sector, style, or stock consistently outperforms its peers, having core holdings invested in broad-market indices not only helps reduce volatility but also can achieve competitive returns for the overall portfolio," it adds.
The explosion in popularity of ETFs has caught very few investment professional investors off guard. Driving the surge in ETF interest is the attraction of lower fees than actively managed mutual funds, as well as the benefits of a wide range of sectors, geographies and strategies. On top of this ETFs are highly liquid in that a nimble investor can buy and sell an ETF a number of times throughout a single trading session whereas a mutual fund is priced once after the end of the trading day.
ETFs also lend themselves very well to technical analysis, often bouncing from support or failing at resistance lines. This can often make the identification of buying/selling areas easier to spot.
"It is expected that the growth in ETFs will continue to increase over the next few years. This will be fuelled by newer, innovative ETF listings along the lines of ones we have already recently seen," says Fletcher.
As the job of most portfolio managers has become broader and deeper, covering all the developed and emerging markets as well as looking at sectors and countries, many are finding that they neither possess the time nor indeed the resources to add value in all markets. "Most importantly, ETFs give investors the opportunity to participate where markets have been showing promise," says Morgan Stanley.
Mick Gilligan, director of fund research at Killick & Co Stockbrokers in London, concurs, saying ETFs are for people who want to take control of their investment decisions.
"We are just providing them with another sort of investment tool box," he says. "There's much more choice available to investors. The structure of ETFs is much more creative in putting investment products together."
No fly by night investment vehicle
ETFs are hardly the new kid on the investment block. They were first introduced to the Toronto Stock Exchange in 1990, sparking a new era in investment products. In the mid 1990s the American Stock Exchange started trading them and since then their popularity has grown exponentially.
According to industry research, at the end of the first quarter of 2008, there were 1,280 ETFs globally with 2,165 listings and assets of $760.8 billion, managed by 79 managers on 42 exchanges around the world. ETF asset under management is expected to exceed $2 trillion in 2011.
Over 2,200 institutional investors worldwide reported using one or more ETFs listed on exchanges around the world during 2006. Over the past nine years, the number of users has increased 1,242 per cent.
With its iShares brand, Barclays Global Investors is the largest ETF manager globally, managing 328 ETFs with 727 listings, and assets of $370.0 billion. State Street Global Advisors is the second largest ETF manager globally, managing 85 ETFs under the SPDR and streetTRACKS brand with 99 listings and assets under management of $135.9 billion.
Costs, transparency, liquidity
The costs associated with ETFs are seen as a major benefit for the investor. They have annual expenses that range from 0.05 per cent to 1.60 per cent, while traditional mutual funds annual expense ratio's range, on average, from 0.39 per cent to 1.91 per cent. ETFs have some of the lowest expense ratios among registered investment products.
Say, for example, a shareholder invested €10,000 for 25 years at a net return of 10 per cent per year, he or she would have €108,347 at the end of the period. The same investment yielding 9.5 per cent (assuming fees were 50 basis points higher) would be worth €96,683.
"From a 'trading mechanics' point of view, the high net worth individual may not have time to pour over charts/company accounts/macro economic outlooks, due to a hectic lifestyle," says Fletcher.
"Thus being able to trade in one go to achieve exposure to a market he has a strong view on, that prior to ETFs would have taken several trades and a lot of work to achieve the same exposure, gives real time and cost savings."
ETFs are also highly transparent, in that the components are disclosed every trading day. In contrast, traditional mutual funds usually reveal their entire holdings just twice a year.
Investors are therefore able to trade with the market at known prices. Most open-end mutual fund investors buy and redeem shares at unknown prices – receiving the net asset value of the fund at the close of the business day.
Like stocks, many ETFs are also extremely liquid. They trade daily on major stock exchanges and investors can place stop or limit orders and even buy on margin and sell short at any time during the trading day at the current market price.
Indeed, the sophistication of ETFs is rapidly becoming a strong selling point for not only the institutional investors but also the traditional family office. For example, short ETFs are now available that enable an investor to buy a fund that will increase in value when the benchmark it (inversely) follows falls.
"ETFs can be used to hedge sector, country or regional exposure. They can be sold short to hedge a portfolio of stocks, allowing an investor to preserve a portfolio while protecting it from overall market losses. ETFs are transparent in that the components are disclosed every trading day. In contrast, traditional mutual funds usually reveal their entire holdings just twice a year," says Morgan Stanley.
William Rhind, head of UK and Irish sales at ETF Securities in London, reckons the birth of commodity-related ETFs has helped propel the investment class into the minds of investors. "At a time of rising commodity prices, family offices can now obtain long, short and leveraged exposure to commodities such as gold, platinum, oil, agriculture, livestock and industrial metals," he says.
Traded on stock exchanges, ETFs are highly liquid and can be bought and sold through any stockbroker. "This gives family offices the confidence that they can buy and sell in size at a time of their choosing. In terms of investment returns, there is no scope for nasty surprises as the ETFs track either spot prices or published commodity indices," says Rhind.
Beware: there are still risks attached
All said, ETFs don't come without their own inherent risks. They are still subject to the same risks applicable to any investment in portfolios of common stocks, including risk of generally lower prices and the chance that they may underperform more concentrated or actively managed portfolios. By targeting performance in line with indices, investors are also forgoing opportunities to outperform.
On top of this, Morgan Stanley claims that ETFs can also from time to time be subject to tracking error risks. "Factors such as expenses, imperfect correlation between an ETF's stocks and those in its underlying index, rounding, changes to indices, and regulatory policies may cause an ETF's return to deviate from that of its underlying index," it warns.
Nevertheless, it is expected that the growth in ETFs will continue to increase. And, as Fletcher says, education appears to be the only thing holding back a further rise in popularity. "The HNW investor can build a diversified portfolio with lower volatility than a traditional portfolio of shares, quickly, easily with low costs and real tax savings," he says.