InvestmentsJun 24 2013

Choosing ETFs over traditional trackers

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So, how are experienced investors using exchange-traded funds (ETFs) in portfolios? Equally, how do they select the most appropriate passive vehicle?

A number of multi-managers use ETFs purely on the grounds of cost, reasoning that lower costs contribute to performance over time. ETFs are available on the major indices for just a few basis points of cost, and many multi-managers believe that, in some cases, active funds may not be worth the additional fees. These managers use passive as a default, only using active when they are convinced a manager can add value predictably over time.

Peter Sleep, senior portfolio manager at Seven Investment Management, says: “We have multi-manager ranges that are active only, and then ranges that actively asset-allocate but are passive. We have found that in some markets – the US, for example – active managers tend to underperform. Our purely passive ranges are much lower cost, and in the past three years they have marginally outperformed their active equivalents.” He points out that 70 per cent of active managers underperform, and that the difference is usually fees. However, he adds: “There is always a cash drag for active managers, because they tend to hold 2-3 per cent cash.”

Then there are some multi-managers who seek active funds by default, but believe passive funds have a place in some markets for longer-term asset allocation. Rob Burdett, co-head of multi-manager at F&C Asset Management, says passive funds can be useful for gaining exposure to a market where active managers have struggled to deliver a consistent risk-adjusted return over and above the market. He says this is true for the US market, and even for emerging markets.

ETFs can also be used to provide more nuanced exposure in a portfolio. For example, ‘quasi-active’ ETFs that prioritise dividend stocks are now available, such as the SPDR S&P UK Dividend Aristocrats. These allow advisers to skew the balance of a portfolio towards dividend-paying stocks or particular markets. They can also be used to take punchier short-term bets in areas such as smaller companies.

ETFs are the only way to access some asset classes, notably commodities. The stunning rise in the gold price in recent years has not been replicated in funds investing in gold shares, largely because gold mining companies have other considerations at work – strength of management, balance sheet leverage, the efficiency of their exploration. Therefore, ETFs have been the only way for most investors to participate in that rally (and its subsequent crash). The same is true for the oil price and agricultural commodities.

But when should investors use ETFs, and when should they use other passive funds? Nick Blake, head of retail at Vanguard, which offers both ETFs and open-ended passive funds, says cost will be an important factor in selecting the right passive vehicle – both the cost of buying the fund itself and the total cost of ownership, including platform fees.

He says: “There is the ongoing cost of the fund and how much an investor gets charged for an equivalent fund. There will be different prices for an ETF and a fund – ETFs will generally be more expensive. The reverse is true at Vanguard, simply because ETFs are slightly cheaper to manufacture because we don’t have to maintain a shareholder register. With an ETF, you have to pay a bid-offer spread. That is usually quite a tiny proportion of the overall entry cost for a liquid ETF.”

However, investors also have to consider the cost of holding, according to Mr Blake. “Traditionally, most products are bought through platforms,” he says. “Investors will typically pay 0.25 per cent or thereabouts in platform costs for custody and administration of the fund. They may not have understood this before the RDR, but these charges should now be explicit. On a typical stockbroking platform, investors will pay £10 or so as a transaction fee.

“Buyers of passive funds will generally be buy-and-hold investors. If they have to pay 0.25 per cent just to hold it on a platform, it is costing them more than the price of the fund,” he adds.

The risks are different, too, depending on the nature of the passive investment. Mr Blake says investors have to ask themselves if they care about whether a fund is synthetically or physically replicated. Most passive funds are physically replicated, so it is less of a concern, but investors have to look under the bonnet with ETFs. They may have no preference, but they need to be aware of the potential counterparty and collateral risk for synthetic strategies.

ETFs are a way to lower costs, take strategic active allocation positions or gain exposure to asset classes that are otherwise unavailable, but alternative passive vehicles are sometimes appropriate.

Cherry Reynard is a freelance journalist