ETFs: A Look under the bonnet
First published in the FM Report
Exchange Traded Funds (ETFs) are not new – first appearing as equity index trackers in the US during the 1990s, but they have ballooned in both number and size of assets in recent years. By the end of 2017 there were thousands of individual ETFs managing over $4 trillion in assets. In this article we take a brief look at some of the key features to be considered when deciding on investment using ETFs.
ETFs are marketable securities that track the performance of an underlying asset such as a stock or bond index, a particular sector or country within the global stock markets, a commodity or some other asset class.
The main differences between an ETF and a traditional investment fund are that the ETF is available to trade intraday on a stock exchange, whereas the traditional fund is typically tradable just once daily at the closing price. ETFs generally cost less in management fees and don’t have investment minimums unlike many traditional funds.
ETF as an investment vehicle
ETFs provide flexibility for retail investors. Previously it was time consuming, costly and cumbersome to access certain investment strategies. ETFs have driven costs down and brought investment opportunities to the individual that were only available to professionals in the past. An investor can for example now easily invest in individual equity and bond market sectors; individual country or regional indices; strategies like small cap, value, smart beta, sustainability and many more. That said, investment funds can still provide better access to investment strategies than ETFs at times.
Active vs. Passive
The ETF market has benefited enormously from the trend shift out of active into passive management, and from a drive to lower the costs of investing. Active management, where managers attempt to beat the market, has received a lot of bad press for underperformance in the current bull market. Passive management, also known as indexing, usually aims to mimic the return of an underlying index and generally costs less than active strategies. There is no guarantee that the relative performance of the two will continue to diverge, and the appropriate investment strategy for an individual does not have to be all of one or all of the other. However recent performance has helped accelerate the move to passive funds and ETFs in general.
ETF management fees are typically lower than a traditional investment fund, but low fees alone should not be the sole determinant of choosing one over the other. Fees within the ETF market can also vary widely, sometimes as low as 0.10% for a simple index tracker and perhaps as much as 0.75% or higher for a specific strategy.
Just like a traditional fund, investors need to do their research before choosing an ETF. It’s not as simple as logging on to a brokerage or pension account and picking from a selection of tickers on the screen. Investors need to do their due diligence, know what they are investing in and whether it is designed to deliver what they are trying to achieve. Your Financial Adviser can analyse what you are buying; for example the manager of the ETF and how it is constructed, what it is invested in and how the underlyings are weighted, underlying liquidity, total fees, tracking error vs. underlying, how the P/E is calculated and more.
Not all ETFs are created equal
There are myriad different ETF strategies. The biggest liquid ETF securities are trackers that aim to return the performance of an index like the S&P500, Dow Jones Industrials or FTSE 100. Many ETFs are designed to offer investors exposure to specific sectors of the equity market, investment strategies like value or momentum, gold, commodity indices and many more. At the other extreme you will find more esoteric ETFs, such as leveraged or inverse ETFs and highly complex volatility structures. Neither equity nor interest rate volatility is widely understood by retail investors, and one might argue that they are far from being suitable products for individuals. As with any investment, seek professional advice if you are unsure.
Physical vs. Synthetic
ETFs can be constructed physically where the index is fully replicated by buying the underlying securities. This is often the case with the likes of S&P500, Dow Jones or FTSE index trackers. On the other end of the scale some ETFs are constructed synthetically with derivative securities – contracts between parties to pay/receive the return on an underlying asset rather than investing directly in the asset. This may be the case with ETFs seeking to track an illiquid index or a commodity basket for example. Other ETFs will use a balance of physical and synthetic. Synthetically replicated ETFs may carry an additional counterparty risk for the investor because of the derivative contracts between ETF issuer and derivative dealer.
Taxation of ETFs can be complex and will depend on the type of ETF security and your tax residency. This article does not constitute tax advice. For further detail you should seek professional advice from your tax adviser.
As a guideline for Irish tax residents, Revenue will generally tax income or dividends on ETFs listed outside the EU at their marginal rate of income tax, while capital gains are taxed at the prevailing rate of CGT (with losses allowable vs. gains). ETFs listed within the EU are generally taxed by Revenue as investment funds, subject to the prevailing rate of exit tax on income, dividend and capital gains (losses not allowable vs. gains). Income or gains will need to be reported to Revenue in your annual tax return.
Liquidity in markets can be described as the ability to buy and sell when you want without impacting the price of an asset. Investors sometimes forget about liquidity during periods of calm markets with values trending higher which has generally been the case since the end of the financial crisis. However it is important to understand how quickly liquidity can evaporate during crisis periods. This may not matter much to the long-term investor or those invested in the largest index tracking ETFs with multi-billions under management and large daily turnover. But it might matter a lot to those with shorter term investment horizons, or those investing in for example high yield bond funds where the underlying securities trade infrequently and in small size. Niche ETFs have not been properly tested in a bear market. The key takeaway is to fully understand what you are investing in.
Whilst not new, ETFs and indexing have become a significant feature of global trading and investment markets in recent years. These developments have brought many benefits to both individual and institutional investors, but as always with financial innovation these benefits come with new risks. ETFs are extremely easy to transact for even the novice investor, but not necessarily so easy to comprehend. Investors who do not fully understand what they are buying should consider seeking the guidance of a professional Financial Adviser.
Ardbrack Financial Limited.
Disclaimer: The content of this article is for general information purposes only. It does not constitute tax or investment advice as it does not take into account the investment objectives, knowledge and experience or financial situation of any particular person or persons. You are advised to obtain professional advice suitable to your own individual circumstances. Ardbrack Financial Limited makes no representations as to the accuracy; validity or completeness of the information contained herein and will not be held liable for any errors or omissions.
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