"Tracker Shares" for Your Portfolio

Nigel Aitkins - Mon 21 Apr, 2008

Exchange traded funds are a cheap, flexible way of accessing stock markets

Exchange traded funds are the sharp new kids on the block. They’re cheap, convenient and choice is increasing fast says Nick Sudbury of the Zurich Club...

In the current difficult conditions the best long-term growth opportunities tend to come from the less mainstream parts of the market. One of the cheapest and most flexible ways of gaining exposure to these potentially profitable, but difficult to access areas, is via an Exchange Traded Fund (ETF).

ETFs are essentially index funds that are listed and traded on the stock exchange like ordinary shares. Often in fact referred to as tracker shares, they allow investors to cheaply mirror the performance of an index, but unlike conventional funds can be bought and sold at any time during the day. This makes them suitable both as long-term core portfolio holdings and for more tactical investments in undervalued markets.

Prior to December 2006 the only ETFs listed on the London stock exchange were those issued by iShares, the Exchange Traded Fund arm of Barclays Global Investors. That all changed when the Chancellor scrapped stamp duty on ETFs domiciled outside of the UK. This had the effect of opening up the market to overseas providers and these firms have since issued an innovative range of new funds in London. Investors with a suitable broking account can also access any of the myriad of ETFs traded in Continental Europe and the States.

ETFs have some of the lowest annual charges of all collective investment schemes and as there is no stamp duty the only purchase cost is the broker’s commission, which is generally the same as when buying shares. Most of these funds can be sheltered in an ISA or SIPP, and since prices are calculated continuously they can all be bought and sold whenever the market is open.

With traditional trackers investors have to deal directly or indirectly with the fund provider, which in turn has to manage every individual subscription and redemption. ETFs are also created or redeemed to match the market demand, but this process takes place between the market maker and the fund manager/custodian.

These institutions actively swap blocks of the underlying holdings in return for units in the ETF, which is an extremely efficient process that enables the annual management costs to be kept to a minimum. The upshot of all this is that there should always be enough supply to meet the demand, with investors being able to buy and sell ETFs through their stockbroker whenever they want. This redemption and creation process also ensures that ETFs trade near to their NAV, which means these funds should closely follow their associated benchmarks.

ETFs provide investors with a low cost means of replicating the sort of core/satellite portfolio long favoured by institutional pension funds. The theory behind this is that the bulk of the money is held in regional index trackers in an appropriate asset allocation to meet the long-term financial objective. In order to boost the overall returns the remaining cash is then split into smaller parcels and invested in those higher risk areas that are thought to offer the best prospects.

There are numerous ways of using ETFs to build the core element of a portfolio. One option for the equity component would be to combine the FTSE All-Share and FTSE All-World ex UK funds from db xtrackers. It would then be possible to use the Barclays iShares to add other asset classes such as fixed income and property, with Lyxor or ETF Securities providing the exposure to commodities.

The satellite component of the portfolio would be made up of a number of higher risk areas to provide additional growth. These could include the likes of single country emerging markets funds like those tracking Brazil, Russia, India and China. There are also ETFs that provide exposure to specific themes such as private equity, global infrastructure and alternative energy providers.

Investors who are prepared to adopt a more active approach can go one step further and use ETFs to take advantage of short-term fluctuations in the markets. This could involve buying an exposure to the Dow in anticipation of a bounce in the US or using the commodity ETFs to exploit the movements in the price of gold or oil.

It is generally accepted that the best long-term growth prospects come from the so-called BRIC countries of Brazil, Russia, India and China. The returns from these markets have been extremely volatile this year on the back of concerns of a possible US recession, but investors with a bullish outlook who see this as nothing more than a temporary setback can use ETFs to gain exposure to these fast growing areas.

One option would be Deutsche Bank’s db xtrackers, which are benchmarked against MSCI Brazil, MSCI Russia, the CNX Nifty in India and the FTSE Xinhua China 25. The alternative is to use the ETFs from Lyxor Asset Management, a wholly owned subsidiary of Société Générale. The company offers both a sterling and a dollar denominated exposure to each market based on different indices to those followed by the db x-trackers.

Investors who are nervous about the short-term prospects for the markets may be more interested in the planned launch of a sterling overnight money market ETF by db x-trackers. This could be a good way of obtaining a decent cash return for money held in an ISA or SIPP. If all goes to plan the new fund should be available shortly.

One of the most dominant investment themes of the last few years has been the surge in commodity prices. The headlines have tended to focus on the recent all-time highs recorded by gold and oil, but many of the agricultural markets are also trading at unusually inflated prices. All of these areas are easily accessible via the exchange traded commodities (ETCs) provided by ETF Securities.

ETCs are similar in principle to exchange traded funds and there are now over 100 of them on the market. Some are linked to single commodities and others to more diversified indices. There are also short ETCs that are designed to make money if the underlying falls in value, as well as leveraged alternatives that magnify the size of the price movements.

For more information and links to all the factsheets go to: www.londonstockexchange.com/etfs

ETF providers operating in the UK Range of ETFs listed on the LSE Barclays iShares 56 ETFs tracking the major equity indices and various other asset classes. www.ishares.com

Deutsche Bank db x-trackers offer 22 ETFs tracking single country and regional equity indices. www.dbxtrackers.co.uk

ETF Securities Offer over 100 ETCs tracking commodity prices including those offering leveraged www.etfsecurities.com and short exposures.

Invesco PowerShares offer 16 ETFs providing exposure to specialist investment themes. www.powershares.net

Lyxor – part of Société Générale offer 39 ETFs tracking single country and regional indices as well as more bespoke measures based on the underlying fundamentals. www.lyxoretf.co.uk

SPA ETF 6 ETFs that track fundamentally-driven indices designed to outperform the markets. www.spa-etf.com

Regards,

Nick Sudbury
For The Daily Reckoning