Regulatory requirements and picking the best ETP

With no commission included within an ETF, Ben Thompson, director of business development, listed products and ETF UK of Lyxor, says they have long been Retail Distribution Review ready.

In fact, Mr Thompson says advisers have been encouraged to pay specific attention to ETFs as an example of an unbundled product that they should consider within an ‘independent review’.

Mr Thompson says: “The Financial Conduct Authority actually said that advisers need to know about ETFs and include them within their client assessments.”

Similar to other investment vehicles, Hortense Bioy, director of passive funds research at Morningstar, says exchange-traded funds require that you do your homework and evaluate them properly.

According to Ms Bioy you should look at five basic elements: suitability, fundamental view, index construction, product construction and last, but certainly not least, costs.

According to Mr Thompson, the three questions an adviser should ask themselves when evaluating an ETF are:

1) How does the ETF performs versus the benchmark (tracking difference)?

2) How does the ETF behaves versus the benchmark (tracking error)?

3) What is the cost of buying and selling an ETF (bid/offer spread)?

Each element has a significant effect on how efficiently an ETF tracks its benchmark index, according to Mr Thompson.

He says: “This is important for investors and their advisers who are trying to evaluate one fund against another as the benefit of a low TER can easily be outweighed by poor tracking or a wide bid/ask spread.

“The bid/offer and volume information will be accessible on the London Stock Exchange, and the performance and tracking error should be published by the ETF provider, notably in the KIID.”

There are also a number of factors that are specific to the ETF that advisers should take into consideration regarding the actual index that the ETF provides exposure to, according to Mr Thompson.

Linked to the index question is the replication method: some indices are better suited to physical replication, others synthetic.

However, Mr Thompson says the key thing to note either way is how is risk managed within the structure. If the fund uses securities lending, how is this managed, how much of the ETFs portfolio can be leant at any time, what can be used as collateral and who can be leant to?

Similarly, with ETFs using a swap structure, Mr Thompson says advisers should question how is the swap managed in order to ensure the fund complies with the maximum counterparty exposure limit of 10 per cent of the net asset value, what does the fund hold as security, re the fund assets owned by the fund or the Investment bank issuing the swap?

All these elements will affect how robust the fund is, how clearly advisers can assess any risks, and how liquid it will be should they wish to exit their position.