Offering a number of advantages over traditional indexed investment funds, the exchange traded funds industry has grown to £86bn in the US but failed to repeat that success in the UK
In today's increasingly global marketplace, most innovative financial concepts that originate in the US typically find their way to these shores soon after they have been developed ' and exchange traded funds (ETFs) are no exception.
Based on an academic paper written in 1976 and pioneered by Leyland, O'Brien and Rubenstein Associates (LOR) in 1990, ETFs initially emerged as experimental underlying securities for hedge funds.
However, the story was not properly set in motion until 1993, when State Street Global Advisers ' the world's second largest indexer after Barclays Global Investors (BGI) ' launched the world's first ETF in partnership with the American Stock Exchange (Amex).
Tracking the S&P 500, the Standard & Poors Depository Receipt (SPDR), or Spider as it has become more popularly known, was initially targeted at institutional investors, although, like other ETFs, it has since evolved to vie for the attentions of institutional and retail investors alike.
Although ETFs are essentially open-ended index tracker funds, they are listed and traded as quoted companies with a net asset value (NAV) on one of a number of stock exchanges around the world.
Given these hybrid characteristics, they are aptly marketed in the US as unit investment trusts. The UK's first ETF, for instance, introduced by BGI under its iShares brand in April 2000 and based on the ubiquitous FTSE 100 index, is listed on the London Stock Exchange's extraMARK exchange, traded on SETS and settled electronically on a T+3 basis on Crest.
Although often confused with the Trains and Linkers securities, launched a couple of years ago by HSBC and Barclays Capital respectively, the only structural similarity these products share with the original iShares is the index they each track.
ETFs have other distinguishing features that double up as advantages over the more traditional indexed investment funds against which they compete. These include the fact they are:
• Based on a wide variety of benchmark equity indices as well as a range of sector and theme-specific indices and industry baskets. Inevitably, some are more liquid, or more easily tradeable, than others.
• Tax efficient, in that ETF purchases made on the LSE are not directly subject to stamp duty, assuming the fund is domiciled outside of the UK, although stamp duty is applied to purchases of the underlying securities that comprise the index being tracked.
• Two-way priced in real time rather than on a forward pricing basis, thereby enabling investors, regardless of their time horizon and investment strategy, to gain instant exposure at a known price to a market, sector or theme at any time during the trading day. ETFs can also be purchased on margin and short sold.
• Transparent, in that details of the fund's holdings, NAV and bid and offer prices can be accessed online.
• Subject to expense ratios as low as 0.09% and bid/offer spreads averaging 0.5%. Moreover, no front or back-end charges are applied. ETF expenses are usually paid out of the fund's dividend income, which is typically paid out or reinvested quarterly or semi-annually.
Similarities with indexed collective investment funds draw on the best features of the latter, principally, the treatment of capital gains and income and eligibility for Pep and Isa investment.
One of the few disadvantages over indexed collective investment funds is that brokerage costs are incurred every time a deal is executed, although these can be as low as 0.5% or £10 per trade. Broadly speaking, ETFs provide a cost-effective and more flexible alternative to traditional indexed mutual funds.
Given the nature of their advantages over traditional indexed mutual funds, the mechanism by which ETFs are created and redeemed is necessarily unique.
First, unlike mutual fund prov- iders, ETF sponsors do not sell ETF shares directly to the public. Instead, they exchange, in the so-called primary market, large blocks of ETF shares, typically 50,000 at a time. Each is known as a creation unit or basket, with institutional investors for the securities of those companies that make up the underlying index being tracked and a cash component representing accumulated dividends. It is at this point that stamp duty is incurred by the ETF sponsor.
Some of these institutional investors hold creation units within their own portfolios while others break up their units and offer the underlying ETF shares in the secondary market of those exchanges on which the ETF is listed. It is in these secondary markets that individual investors can trade ETFs via broker-dealers, just as they would any other listed security. Interestingly, ETFs can only be issued and subsequently traded at less than £100 per share ' iShares were launched at £10 per share.
Redeeming ETFs works in reverse. Broker-dealers buy enough ETF shares from individual investors to make a creation unit block and then exchange these blocks for a basket of securities and a small amount of cash, representing the NAV of the fund and accumulated dividends respectively, with the ETF sponsor.
Other institutional investors can similarly trade back the creation units in their portfolio with the ETF sponsor for securities and cash. Given the extent of this behind-the-scenes swapping of securities, creation units are continually created and redeemed according to investor demand, as well as for arbitrage purposes.
This latter point is particularly important. As institutional investors can continually exchange creation units for the securities underlying the index being tracked by the ETF at NAV and visa versa, any premiums or discounts to NAV that arise are soon arbitraged away with the result that ETF values closely track those of the underlying securities. Indeed, for larger, more liquid ETFs, premiums and discounts rarely exceed 0.2% of net asset value.
In the US, much as in the UK, ETFs initially met with a lukewarm response. Today, however, the US ETF industry, which comprises more than 100 funds, has blossomed into a $86bn (£60bn) market, split between institutional, hedge fund and retail investors.
It also boasts an average daily trading volume of $6.8bn (£4.75bn), 10% of which is generated on the New York Stock Exchange, which began listing ETFs in 2000.
To put this rapid growth into context, the ETF industry is dwarfed by the near $7,000bn held in US mutual funds but is, in fairness, on a par with the Vanguard S&P 500 fund, the US's largest index tracker and second only in size to the mighty Magellan.
Having also become popular on the Continent, with a similar number of ETFs collectively listed in Germany, Switzerland, Sweden and on Euronext ' the Paris-Amsterdam-Brussels stock and derivatives exchange ' ETF sponsors have recently made a foray into the Asian market.
Ironically, the main reason for ETFs not having widely captured investors' imaginations in the UK, principally stems from their low expense ratios and keen charging structures. This has resulted in low public awareness because of small advertising budgets and the inability to remunerate advisers to promote and distribute these innovative products.
However, the relative lack of sophistication among UK investors, certainly when compared to that of their US counterparts, and investor inertia have also been contributory factors.
This may be set to change, as those ETFs listed and traded on the Deutsche Börse, the German stock exchange, principally the offerings of Merrill Lynch, UBS, HypoVereinsbank and Union Invest, are to be made available via UK intermediaries through the white-labelling route.
The Frankfurt-based stock exchange also intends to make these products available through selected fund supermarkets. Given ETFs' highly competitive charging structures, initial and trail commission will more than likely be funded by marketing these products via tax wrappers.
State Street Global Advisers, having recently obtained FSA recognition for their Street Tracks ETFs, based on a selection of MSCI indices and traded on Euronext, is also intending to extend its product to the UK retail channel. All ETFs marketed in the UK must be either Ucits compliant or FSA recognised.
If the US experience is anything to go by, there is no doubt that, in time, ETFs will capture a significant proportion of the UK open-ended index tracker fund market. Indeed, at $28bn (£20bn), the Spider ETF alone already exceeds the size of all but the very largest US mutual funds.
Longer term, however, the challenge must be to further penetrate the potential investor base through product enhancements and innovation. For example, through HOLDRS, Merrill Lynch not only provides investors with diversified exposure to specific industries and sectors, such as biotechnology, software and pharmaceuticals, but also enables investors to unbundle their underlying portfolio of securities.
Over time, notwithstanding the difficulty associated with continuous pricing and the fact the product must be capable of being traded on SETS and settled through Crest, a variety of possibilities exist. The ETF concept may be extended to actively managed funds, index tilts, more esoteric indices and possibly even securitised products. The possibilities are endless. Whether the UK investment funds industry takes the initiative to develop these products independently or continues to take its lead from the US remains to be seen.
Chris Wagstaff is director of investment training company Investment Matters (UK)
key points
ETFs originally emerged as experimental underlying securities for hedge funds.
Details of an ETF's holdings, NAV and bid and offer prices can be accessed online.
ETFs can only be issued and subsequently traded at less than £100 per share.
