x Abu Dhabi, UAEThursday 18 January 2018

The appeal of ETF investing

Cheap, transparent and tax efficient, hundreds of exchange-traded funds available in dozens of global markets.

In 2008 the number of ETFs increased by 36 per cent, with net sales surging to US$187.5 billion (Dh688bn). By contrast, mutual funds suffered net redemptions of $256.7bn.
In 2008 the number of ETFs increased by 36 per cent, with net sales surging to US$187.5 billion (Dh688bn). By contrast, mutual funds suffered net redemptions of $256.7bn.

Exchange-traded funds (ETF) have been the most successful financial product of the new century, and ETFs focused on the Middle East have mushroomed in just the last year to nearly a dozen that trade in New York, London and elsewhere in Europe. ETFs are gaining adherents because they are cheap, tax efficient and transparent in their holdings and operations. They trade throughout the day, rather than only at market close, and are free of red tape such as redemption fees and rules against frequent trading. They target more asset classes than do mutual funds, including gold bullion, agricultural commodities and currencies. Hundreds of them target specific industries and sectors, allowing individuals to fine-tune their holdings.

While the US market for ETFs is the oldest, largest and most liquid, substantial trading has grown up in global bourses, particularly those of the English-speaking world. With many financial advisers counselling their expatriate clients to invest strictly in their home marketplaces, that is particularly easy to do with ETFs. But while ETFs can improve almost any investment portfolio, local options are a two-edged sword for people living in the Middle East. On the plus side, you know the region far better than for investors back home, giving you an edge.

But already your salary, bonus, stock options or ESPP (employee stock purchase plan) are all probably tied to the ups and downs of the region, says Tom Zachystal, the president of Individual Asset Management, a San Francisco-based advisory firm with an expatriate clientele. "In my opinion, it makes sense for you to underweight [the Middle East] in your investment portfolio - something that can be done by using other ETFs."

There are plenty to use. At the end of 2008, some 1,590 ETFs were listed on 42 exchanges around the world, notably in New York, Toronto, London and Sydney, according to Barclays Global Investors, sponsor of the dominant iShares brand. That is a rise from zero in 1993, when they were introduced in the United States, and only a few dozen in 2000, when they spread to Europe and then Asia. Despite a global bear market for equities, the number of ETFs leapt 36 per cent just last year, and their net sales surged US$187.5 billion (Dh688.59bn), even as mutual funds, their main competitor, suffered net redemptions of $256.7bn.

The ETFs that target the MENA region reflect the variety of different strategies that can be utilised by these funds even when they target relatively small niches. iShares MSCI GCC Countries ex-Saudi Arabia, which trades in London and is designed for British and Irish investors, tracks an index of companies in the Gulf Cooperation Council with the exception of Saudi Arabia. They include Kuwait (54 per cent), United Arab Emirates (20 per cent), Qatar (16 per cent), Oman (6 per cent) and Bahrain (4 per cent). Reflecting the fact that energy producers in the region are state-owned and therefore don't trade public shares, this ETF has 68 per cent of assets in financials, 13 per cent in telecommunications and 10 per cent in industrials.

Told holdings include Kuwait Finance House, National Bank of Kuwait, Mobile Telecommunications, Commercial Bank of Kuwait and Emaar Properties. All of the MENA ETFs are relatively new, though the Middle East Spider was introduced in March of 2007, two years before the iShares ETF, and therefore has a track record. As of April 30, the fund was ahead 8.5 per cent in the most recent three months and 4.6 per cent for the year to date, while down 31.8 per cent for the preceding 12 months.

Liquidity The credit crisis that began in the United States in 2007 and subsequently spread around the world has raised profound questions about counterparty risk, transparency, liquidity and the use of derivatives and structured products, says Deborah Fuhr, the global head of ETF research and implementation strategy for Barclays Global Investors in London. ETFs benefit from these concerns, Mr Fuhr says, because they are among the most liquid and transparent investments on the market. They begin with an index.

The most widely owned ETFs represent broad market indices, notably the Standard & Poor's 500 Index for US stocks and Morgan Stanley Capital International's EAFE for the balance of the developed world. But just about any marketplace can be indexed; there are more than 50 ETFs that track Russell indices, 100 tied to Dow Jones, 120 to the FTSE, 160 to STOXX and so on. An ETF owns all or most of the securities in the index it is linked to; what it owns, precisely and in complete detail, is published daily.

The ETF is created through a swap between the sponsor, which puts up shares of the ETF, and a counterparty, such as a bank or brokerage firm, which puts up shares of the constituent securities. These institutional baskets of stocks and bonds are called creation units, and enough of them are created to meet demand for ETF shares. If that demand declines, ETF shares are destroyed when creation units are redeemed.

None of this involves buying and selling; these are trades, not purchases and sales. So there are no capital gains (or losses) to create a tax headache for shareholders. Some, notably fixed-income ETFs, do distribute dividends, but by and large they do not run up the kind of tax bills that mutual funds do. The ETF shares trade on exchanges as stocks do, throughout the day. Every fifteen seconds the ETF reports its net asset value (NAV), which is the combined prices of all its constituent securities divided by the number of shares outstanding. Most large banks, brokerage firms and investment banks have ETF desks that compare this NAV with the market price of the ETF itself. If the two diverge, these institutions arbitrage away the difference, meaning they buy ETF shares and exchange them for the relevant securities if the fund is underpriced, and vice versa if the fund is overpriced.

This is a huge advantage over the other kind of exchange-traded fund, called a closed-end fun. These are fixed portfolios, which like ETFs trade throughout the day, but their exact holdings are not known moment to moment, and so any discount or premium to NAV cannot be arbitraged away. Those discounts and premiums are, therefore, ubiquitous in the closed-end fund world, and often extreme. Portfolio benefits

The advantages of ETFs do not end there. They are more economical to operate than mutual funds because they do not have to support an infrastructure of banks' and securities firms' research departments. ETFs are managed by computers. While the typical equity mutual fund charges annual expenses on the order of 1.5 per cent, most ETFs charge less than 0.5 per cent. Mutual funds have a vested interest in making it hard for you to get your money back: they are paid according to assets under management.

Redemption fees and other schemes to discourage you from selling shares are thus the norm. ETFs have no such restrictions; frequent trading just costs you more commissions, and they do not go to the ETF company; they go to your broker. The ETF marketplace is, moreover, remarkably diverse. Some of its biggest customers are institutions such as pension funds and insurance companies, which follow a regime of asset allocation. Institutional investors like to slice and dice their holdings very finely, and ETFs can be created to meet virtually any such need.

While the largest ETFs are those linked to broad indices such as the S&P 500 and EAFE, the largest number are tied to smaller subsets. There are ETFs devoted to large-capitalisation stocks, small caps and mid caps. Some target growth and others value. Some target sectors as broad as technology, and others concentrate on industries as small as semiconductor manufacturing. ETFs address developed markets, emerging markets and "frontier" markets like those in the Middle East.

Popular assets ETFs also provide access to marketplaces and strategies that have been hard to enter otherwise. Leveraged and inverse leveraged ETFs have become enormously popular during the recent bear market. The leveraged type promise two or more times the performance of a benchmark; in effect, delivering the same results as buying on margin, without having a margin account. The inverse type delivers mirror-image performance, going up when the target benchmark goes down, effectively the same as selling short, a strategy that is forbidden in many brokerage accounts. There are also inverse ETFs that use leverage.

Exchange-traded notes (ETN) have also emerged, principally in Europe. These are bank debt, rather than actual securities, which constitute a promise to deliver the return of an index. They are not unlike European certificates, except that those can only be sold back to the issuer, whereas ETNs can be traded freely. ETFs have the advantage that they are not vulnerable to tracking error. Any index fund, not just ETFs, can wander away from its target, whether because of the perverse effects of compounding (10 per cent up and 10 per cent down are not necessarily equal) or simple mismanagement. One iShares ETF linked to the MSCI Emerging Markets Index fell short of its target by 4.8 percentage points in 2007. ETNs, being purely synthetic, never miss their marks.

ETFs are also able to own assets outside the usual managed portfolio world, such as gold and silver bullion. One US-listed ETF, SPDR Gold Shares, (which is also listed in Singapore, Tokyo and Hong Kong) actually owns 35.6 million troy ounces of physical gold, more than 1,100 tonnes, a greater holding than all but six of the world's nations. ETFs can also own financial derivatives, such as futures and options. This opens the door to investing in agricultural commodities, which were previously largely restricted to professionals such as farmers and speculators.

Finally, ETFs and ETNs can invest in currencies. All of the major trading currencies, including the British pound and the American and Canadian dollar, can be purchased in the form of fund shares, and in some cases can be effectively shorted through inverse funds. Disadvantages If ETFs have an Achilles heel, it is that buying them in small quantities is not very economical, unless your broker gives you free commissions. In the largest ETF market, the United States, even the cheapest commissions are around $4 a time, which on a purchase of $200 of ETFs would be 2 per cent. When spread out over lump sum purchases, however, commissions can be virtually nil, and the extraordinarily low annual fees make total ownership costs of ETFs the lowest of any professionally managed investment product.

As a practical matter, ETFs are not quite as perfect as they could be, because of the regulatory environments in which they operate. Sector funds, in particular, are crafted for the regions where they trade. US sector funds specialise in US companies (although some with "global" in the name will own non-US securities), while those sold in Europe and Asia target companies headquartered in those regions.

The regulations that govern ETFs around the world are all very similar, however, in part because they are relatively new. So wherever they are based, ETFs are more similar to each other than most rival products. While ETFs are also cheaper than rival investment products, they are also more expensive than they have to be. The biggest global brand is iShares, owned by the British bank Barclays. A deal to sell iShares for $4.4bn has been struck by Barclays with a European private equity firm, CVC Capital Partners. Morningstar, an American fund-consulting firm, estimates that the iShares business threw off $480 million in operating profits, before interest and taxes, in 2008.

However, iShares has plenty of competitors, ranging from Vanguard Group and State Street Global Advisors in the United States to Lyxor Asset Management in Paris and Deutsche Bank in Frankfurt. Thanks to this competition, the pressure on fees in the ETF world is downward. That is great for us investors, because every dime saved in fees is a dollar more you'll have in retirement. You get what you don't pay for, and you don't pay much for ETFs.