Scotsman article: Exchange traded funds offer another alternative for your portfolio

11 April 2009

BARCLAYS announced on Thursday that it had sold its iShares subsidiary, raising much-needed cash from the sale.

It agreed to sell the business to CVC Capital Partners Group and will finance $3.1bn of the total $4.4bn purchase price. But what is iShares?

The iShares brand provides exchange traded funds (ETFs). These have been around since the mid-1990s, but have only recently grown exponentially in popularity, particularly in the US. They are similar to index-tracking funds in that their price reflects movements in an underlying index, sector or commodity, but they differ in a number of important ways.

They are traded in the same way as shares on an exchange. So, unlike mutual funds (unit trusts and OEICs, including index-tracking funds) they can be bought and sold for their current market price at any time during the trading day. Just like any other share, ETFs can also be sold short, or be subject to limit or stop loss orders etc. As ETFs are funds and not derivatives, they allow investors to quickly respond to opportunities and risks in the markets.

Crucially, ETFs have considerably lower costs than mutual funds. Many actively-managed funds will have an initial charge of up to 5.25 per cent and an annual management charge of around 1.75 per cent. The total expense ratio (TER), which gives a better picture of costs, can frequently exceed 2 per cent a year. Index-tracking funds are a lower-cost alternative to actively- managed funds. These tend to levy no initial charge and many offer TERs of less than 50 basis points (0.50 per cent a year).

But ETFs offer lower annual expenses than even the cheapest tracker. For instance, iShares' sterling corporate bond ETF has a TER of 0.2 per cent a year.

ETFs have yet to make an impression in the UK. This is due partly to their low-cost charging structure, which deprives advisers of commissions. They will become more prominent, however, as more advisers embrace a more transparent approach to charging their clients.

In practice, ETFs are bought and sold via a broker, so there will be brokers fees to meet in addition to the ETF charges. However, the fee can be as little as 1 per cent or £7.50 per trade.

As ETFs cannot be readily sold back to the fund manager, like mutual funds, liquidity is an issue. Moreover, while their price should generally reflect the values of the underlying assets, the market forces of supply and demand could skew this relationship, although this tends not to happen in any sustained way.

Despite the growth of ETFs in the UK, most are denominated in US dollars or euros, giving investors additional currency risks to consider. But while many advisers still balk at recommending ETFs, they can play an important role in a diversified portfolio.

Paul Lothian is a director of Verus Chartered Financial Planners in Dundee.

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