Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 45:  Exchange-traded funds (ETFs)  Main characteristics of ETFs  How ETFs are traded 45cis

Exchange-Traded Funds An Exchange-Traded Fund (ETF) is an investment fund designed to track a particular index, or group of assets. A typical index being tracked would be the FTSE 100, which measures the performance of the largest companies trading on the London Stock Exchange. ETFs are a relatively new investment product. They were launched in the USA in 1993 and in the UK in They are now one of the most popular exchange-traded investment products. One of the largest ETF providers in the UK is iShares. iShares was launched by Barclays in In 2009, the parent was acquired by BlackRock According to Barclays Stockbrokers, by September 2009, there were more than 800 of these funds to choose from across Europe, accounting for more than £93 billion of investors’ money.

How ETFs work ETFs are baskets of shares or other tradable assets. They are similar to tracker funds, in that they mirror a particular index such as the FTSE 100 in the UK or S&P 500 in the USA. Key definition: Net asset value per share: the closing market value of all securities owned plus all other assets such as cash, subtracting all liabilities, then dividing the result (total net assets) by the total number of shares / units in issue.  ETFs should not be confused with unit trusts  while unit trust (or mutual fund) prices are based on the net asset value (NAV) of the underlying shares in the fund. ETFs are traded like shares. BlackRock Gold and General Fund (blue line) vs FTSE (red)

Exercise: NAV exercise

Exercise: NAV solution

ETFs and NAV A unit trust (or mutual fund) will always be priced at the NAV per unit, based on the day’s closing prices. But an ETF is priced according to market demand.  If the underlying assets of an ETF are in hot demand, the price can rise to a small premium to its underlying NAV.  Similarly, if the underlying assets go suddenly out of favour, the price of an ETF can dip below the NAV.  Example: bonds when there has been an unexpected interest rate increase  Example: an agriculture-based ETF when a major grain exporting country is experiencing drought DB Agriculture Fund Discount / Premium to NAV

Dealing in ETFs In London, ETFs are traded on the London Stock Exchange. The LSE has established a special sub-set of the exchange for ETFs. This is called extraMARK.  Eleven ETF issuers have listed over 340 ETFs on the London Stock Exchange  In addition, over 190 ETFs are also offered as multi-currency lines  Further 127 ETFs are available through the LSE’s OTC trade reporting service

How ETFs work Because ETFs are traded like ordinary shares, they provide much greater flexibility when it comes to buying and selling  While unit trusts are priced once a day, shares in ETFs are traded on the stock exchange, so the prices move throughout the day.  Investors do not have the problem of shares trading at big discounts or premiums to NAV (which often occurs with closed-end funds, such an investment trusts)  ETFs are open-ended  ETFs are listed on the stock exchange and bought through stockbrokers

How ETFs work One of ETFs’ key strengths is that they bring a wide range of investments within reach that might otherwise be difficult to access efficiently. This makes it cost- effective to trade emerging markets over a short time horizon, or to swap out of UK and into Eurobonds in just two trades, for example  ETFs can track any traded financial asset  ETFs are now available for commodities and corporate bonds. Investors can even buy funds that track more esoteric sectors, such as infrastructure or water.  ETFs charges are less expensive than many open-ended funds  ETFs do not levy front-end charges, early redemption penalties or exit charges.  Service charges are often below 0.5% a year. However, you will have to pay broker-dealing charges, so if you trade a lot it could work out quite expensive.

Costs of dealing in ETFs ETFs have much lower total expense ratios (TER - the total amount of money paid to cover the costs of fund management, trustees, licensing and operational costs as a percentage of the total fund) than traditional unit trusts or active funds, which means lower costs for the investor.  The average TER for fixed-income ETFs is 0.17%, and the average TER for equity funds is 0.40%, making them among the cheapest funds on the market.  The downside to investing in ETFs is that some investors have complained of poor liquidity  Poor liquidity means that it can be difficult to buy or sell in large quantities – a disadvantage in a rapidly moving market Average expenses of ETFs vs open-end funds in Europe Source: Morningstar  In Europe, the average TER for an actively managed mutual fund / unit trust with international equity exposure is 1.76% and for an actively managed bond fund is 1.00%.  In addition, UK investors pay no stamp duty on ETF investments, as the fund managers have already paid duty when buying the underlying shares.  An average index (tracker) fund with international equity exposure has a TER of 0.78%.  ETFs can be placed in ISAs

Costs of dealing in ETFs vs other collective investment schemes It is clearly worth paying a higher TER for consistent outperformance and a high TER does sometimes pay. Take Jupiter Merlin Balanced Portfolio. This popular selling fund has a TER of 2.3 per cent, which is higher than the average – yet it outperforms its peers regularly and is justifiably recommended by many investment advisers Can such high TERs ever be justified?

Investors can make a return on ETFs in the form of dividends paid by the ETF (income). They can also make a return from capital gains. Investment returns from ETFs However, as the fund is likely to be invested in a great number of underlying assets (in excess of 300 for some funds), this has the advantage of spreading the risk over several securities, not just one. Therefore the value of the ETF (i.e. the price) is unlikely to be as volatile as the prices of individual securities. It is important to remember that as the underlying assets of the ETF are tradable instruments such as shares and bonds, it is also quite possible that investors might suffer a capital loss.

Growth in number of institutional investors using ETFs Source: Global ETF Research & Implementation Strategy Team, BlackRock, Thomson Reuters