John Redwood, Charles Stanley’s Chief Global Strategist, has commented on the rising popularity of ETFs. He writes that by the end of June this year, ETFs had swollen to more than USD3 trillion worth of investments.
“In recent years more individuals and institutional investors have built portfolios around ETFs. More institutions have used ETFs to gain exposure rapidly to a given asset class or geographical area. More have introduced some ETFs into portfolios where they lack the expertise on the individual shares or commodities or properties they might otherwise buy,” Redwood says.
“The typical ETF tracks a given share or bond index. If you want to own a stake in corporate USA you can buy an ETF which seeks to mirror the dividends and capital gains or losses of the Standard & Poor’s index of US shares. If you want to buy a modest stake in UK government bonds, you can invest through an ETF which tracks the All Stocks Gilts index for income and capital changes. The simple ETFs closely track their indices by buying all the shares or bonds in their index in the right proportions to match. More complex ETFs may try to do it by sampling the investments to buy, or even by having a small element invested in a swap instrument to keep the return in line with the index.
“As the scale of ETF investment grows, so the industry can offer a better and better deal on expenses. A few years ago it was typical for the ETF manager to charge 0.2 per cent or 0.3 per cent for some of the better-known and more developed liquid markets. This was a lot cheaper than active managers who might typically charge 1 per cent or more. Today the biggest and best known indices can be tracked for less than a 0.1 per cent annual charge. The more of the return you can keep the better your rewards for saving.
“ETFs are also usually relatively easy to buy and sell. You can buy and sell them in the normal way like any other share in the market. If you want to sell your holding in the S & P 500 US Index, there is normally someone somewhere who will want to buy and can take your shares off you. If by any chance it’s a bad day and no willing buyers emerge, the manager of the ETF will cancel your shares and pay you for them, whilst selling underlying shares in his portfolio to raise the cash. It means your investment in the ETF is at least as liquid as the underlying market you are tracking. If you had bought individual shares in the US or UK you might find it more difficult to sell, as sometimes the market dries up in individual company securities. You could end up selling at a large discount,” Redwood writes.
Redwood explains that his firm uses index tracking ETFs to keep the costs down. “They seek to improve returns and balance your risks by switching between different indices depending on news, events and valuations. Other diverse Charles Stanley portfolios use ETFs for specialised parts of the portfolio, to supplement stock picking elsewhere. There are now ETFs which follow particular strategies. For example, you can find ETFs which provide you with a portfolio of shares or bonds with higher income than the average in the chosen market. There are also so called minimum volatility ETFs which seek to buy shares which provide you with fewer shocks in price than the market variations. In each case the fund automatically selects or rejects shares based on pre-arranged criteria, like how much dividend they pay.”
Redwood concludes that watching flows into and out of ETFs every week gives his firm a good indication of market moods and what other investors are doing – which may be something different from what they are saying. “There are big swings in fashion. This year we have seen big outflows from continental European shares and from Japanese shares. These have been matched by large inflows into emerging market shares and bonds, into precious metals, into the USA and into bonds more generally. There have been modest inflows into shares in the UK, Australia and Canada. We do not always go with the flow, though this year we have been part of the mainstream. If you decide to go the other way you might make good money but you need a good reason to disagree. Arguing against the billions moving in the opposite direction requires good arguments and strong nerves,” he concludes.