Defining ETFs for use in portfolios

Defining ETFs for use in portfolios

Although there are a range of factors that wealth managers need to consider when looking at how to use exchange traded funds (ETFs) in their portfolios, it is important first of all to pinpoint what exactly an ETF is, dispel some of the myths, and highlight the benefits they can offer.

ETFs have become popular and widely used investment vehicles. In a world in which new financial products come and go in the blink of an eye, ETFs might well be considered the leading financial innovation of the past two decades.

Since the first fund was launched in Canada in 1990, ETFs have opened a new panorama of investment opportunities. They have fundamentally changed how both institutional and retail investors construct investment portfolios. Essentially, they are index funds (a few ETFs have been launched that are not designed to track an index) that are listed and traded on exchanges like stocks. They also allow investors to gain broad exposure to specific segments of equity markets with relative ease, on a real-time basis, and at a lower cost than many other forms of investing.

Other aspects of ETFs

ETFs are based on sector, large cap, mid cap, small cap, value, growth, domestic, international country and regional equity indices, commodity, currencies as well as on corporate, credit, inflation and government fixed income indices. Typically they can be used to short indexes, are lendable, and are purchased on a commission basis just like other equities.

We believe that growth in the use of ETFs reflects their many advantages. They trade throughout the day on major securities exchanges and can be bought and sold using market, limit, or stop orders.

ETFs are funds, not derivatives, which allow investors to quickly react to short and long-term requirements or opportunities. As such, they may serve as an alternative to futures, trading baskets of stocks and traditional mutual funds.

ETFs do not have any sales loads, although like mutual funds, they do have annual expense ratios – albeit less than traditional funds, ranging from 0.05% to 1.6%. In fact, ETFs have some of the lowest total expense ratios among registered investment products. Recent interest from individual investors has been partly fuelled by attempts to avoid accounting, earnings, and other stock-specific risks.

ETFs provide daily portfolio transparency, are listed and traded on exchanges like stocks on a secondary basis as well as utilising a unique creation and redemption process for primary transactions.

But these vehicles also have distinctive features, with each ETF designed to track a specific index. They provide access to investment styles, asset classes, markets and different sectors.

They are structured as open-ended funds that are domiciled and registered in many countries around the world. Their assets are held by custodians in a ring-fenced structure.

Underlying securities

Most ETFs purchase the underlying securities in the index with the majority fully replicating their underlying index, and many have the capacity to employ optimisation and sampling techniques. These ETFs may exclude certain securities and deviate from their benchmark constituent weights, which could lead to tracking error.

The open-ended structure typically allows funds to lend stock, which may generate extra income. In addition, these funds can hold other securities and financial instruments, including cash and equivalents and futures.

Dividends are typically paid out quarterly, semi-annually or annually, although some ETFs do reinvest dividends in the fund.

In Europe, a new synthetic approach is increasingly being used to create funds and ETFs rather than the physical approach which is the predominant form in the US and many other juridictions around the world.

Synthetic ETFs utilise a total return swap plus a basket of securities to comply with the diversification rules under Ucits to deliver index performance rather than purchasing the underlying securities in the index.

According to the ETF Global Insight end of February 2012 monthly review published on 2 March, 2012, there were 3,144 ETFs with 6,989 listings from 160 providers listed on 50 stock exchanges around the world with $1.5 trillion in assets under management.

However, differences in ETF domicile and structure can cause difference in the tax and regulatory treatment for investors, both of which should be considered.