Evercore Pan-Asset on Exchange Traded Funds (ETF) www.pan-asset.co.uk

Jan. 15, 2009 - PRLog -- What are ETFs

Think of a traditional investment trust but one dedicated to a single asset class - say European equities. Picture this trust holding a portfolio of European equities chosen to exactly replicate the structure and performance of the European equity index so that there is no risk of poor stock picking. Finally, picture this trust having solved the traditional problem of investment trusts that their shares routinely trade at a discount to their underlying asset value so denuding part of their return. In broad terms you are picturing an Exchange Traded Fund.

Now picture an ETF whose specialist single asset class is not a mainstream equity market like Europe but instead Chinese or Indian equities. Picture too an ETF whose single asset class is, for example, global private equity companies, US inflation-linked government bonds, Far East property companies, emerging markets infrastructure companies or global clean energy companies. You are now picturing how the rich universe of ETFs can be used as building blocks to create a truly diverse portfolio.

First launched in the US in 1993, by the end of 2007 there were some 1,200 ETFs world-wide, with assets totalling nearly $800bn. They are a well established investment tool. However, their potential as portfolio building blocks has been transformed over the last three years by a proliferation of new and diverse ETF launches, resulting in a broad universe of investment opportunities.

Investing in Exchange Traded Funds requires professional advice and not all ETFs are suitable for all investors. However, it is now possible to construct balanced, widely diversified investment portfolios comprised more or less entirely of ETFs and tailored to each investor’s different circumstances and requirements. This is where the strengths of traditional investment management, index tracking and alternative investment meet. We believe many investors will conclude that it is the way of the future.


They are each dedicated solely to investing in one particular investment asset class and are  designed to generate investment returns in line with the returns generated by the index for that  asset class. This means that they are the purest way of implementing asset allocation decisions  – they provide one-stop access to a broadly diversified portfolio of investments in their underlying  asset class and there is not the active manager risk that disappointing stock picking within an  asset class may undermine the general return provided by the asset class.  

Studies show that it is asset allocation rather than stock picking which is the key determinant  of the level of long-term investment returns. Over time, few active managers “beat the index”  and many suffer periods of damaging underperformance. For investors whose own experiences  and observations have led them to share these conclusions, ETFs are an ideal way forward.

What are the advantages of ETFs

ETFs offer a number of advantages:

Simplicity

One completely normal stock market trade gives you diverse exposure to the underlying investment asset class. Normal settlement and custody arrangements apply. As Sterling denominated share classes are generally available regardless of the currency of the underlying investments, there is no complicated foreign currency accounting required

Flexibility

This ability to buy into or sell out of a whole asset class with one simple transaction also  means that an investment portfolio can be adjusted quickly and easily in response to  changing stock market conditions. For example, in a suddenly falling market a portfolio’s exposure to UK equities could be, say, halved with just one trade. There is no need for any of the time consuming stock by stock construction of a selling programme that is usually required. They are also a tool for shorting for investors who are so inclined – ETFs can be borrowed to sell short and there is even a breed of short or inverse ETFs which go up proportionately when their underlying index goes down.

Transparency

Since ETFs are index trackers and the composition of their underlying indices is published  at regular intervals, you know exactly what your investment exposure is within each ETF

Liquidity

As ETFs are listed on the stock market, liquidity is assured. The market makers quote  competitive buying and selling prices throughout the dealing day and since ETFs are  open ended funds there is a creation and redemption process between the market makers  and the ETF sponsor that prevent their prices diverging significantly from the underlying  fund asset value. The transparency of ETFs and the fact that the holdings within ETFs  are liquid exchange traded investments, means that any discrepancies that might emerge  are quickly arbitraged away.  Cost Efficiency  

ETFs have no entry or exit fees, dealing spreads are tight and their internal management  fees are much lower than normal pooled funds – typically only 0.2% per annum for cash  and bond ETFs, between 0.3% and 0.7% for equity ETFs and 0.4% to 0.9% for alternative  ETFs. These are often half or less the fees charged by actively managed pooled funds.  Furthermore, no Stamp Duty is payable on secondary market purchases

What makes a Well-Managed ETF?

All other things being equal, the key test of the effectiveness of an ETF is its “tracking error” which is the term for any divergence between the performance of the ETF and the performance of its underlying index. ETF providers publish the tracking error of their funds regularly so they can be closely monitored.

There are several potential sources of tracking error which include:

Transaction costs– each trade within an ETF involves a set of costs, including the spread between the bid and ask prices.

Annual fees– ETFs charge an annual fee that includes the cost of portfolio management and custody of the securities in the funds.

Rebalancing costs– index providers, such as FTSE or S&P, regularly rebalance their indices to reflect securities entering or departing from their indices. In rebalancing, index providers do not take into account the costs and timing considerations of buying and selling securities.

Stock lending revenue– some ETFs generate additional revenue by lending out some of their investments. Stock lending is a well-established and big business. It began as a way of facilitating the prompt settlement of trades but many stock borrowers are now hedge funds who borrow stock in order to sell it short. Stock lending is capable of generating worthwhile revenues though it should be noted that it introduces an element of counterparty risk.

Optimisation leakage– where it is not possible to exactly replicate the index portfolio and ETF managers employ optimisation there can be divergences between the index return and the returns from the securities actually held. This problem does not arise when synthetic replication is used since this tracking methodolgy is capable of eliminating all forms of tracking error other than annual fees.

It can be seen that the key factors in tracking error revolve around costs since an index is a theoretical construction that does not bear any costs.

These costs, however modest, mean that ETFs are bound to underperform their respective indices to an extent. However, this will not matter if the original asset allocation judgement is successful because studies show that this is what really makes the money. It is better to slightly underperform a strong index performance due to moderate costs than risk seeing that successful asset allocation decision undermined by poor stock selection and much higher costs which is the risk with active stock picking.

To learn more please visit our website www.pan-asset.co.uk

# # #

We belive that carefully considered asset allocation decisons is the cruicial part in the investment management process and argue that identifying the correct asset classes in which to invest is more important than selecting the underlying stocks.