PTL's Simon Riviere takes a closer look at the pros and cons of exchange traded funds and asks if trustees should be considering them.
The trustee board had fallen silent; the meeting had been lively up to this point.
"ETFs?" asked one of my co-trustees.
"I've heard of them, but never advised on them," admitted the investment adviser.
"Yes, ETFs," I replied. "Exchange traded funds. They're the new kids on the block in the UK in investment terms, although they've been around in the retail markets for a while now, especially in the USA. ETFs are taking a foothold in the institutional markets and more pension funds in the UK are using them. Globally, there's been strong growth in these products. As trustees, perhaps we should be considering them?" This last question was directed at the investment adviser.
"Perhaps," he replied. "But they don't suit every fund. Let me cover the basics."
ETFs are index-tracking funds and are designed to mirror the performance of an index, such as the FTSE100. These types of 'simple' ETFs aim to track the underlying market or asset class as closely as possible. One of the advantages of an ETF is that they can be bought or sold at any time of the day that the markets are trading. Like a unit trust, shares within the ETF can be created or redeemed and this helps keep the price closely in line with the underlying index or asset, instead of being priced according to supply or demand.
A simple ETF has a number of advantages such as –
- Simplicity: a single trade can provide diverse exposure to a chosen asset class
- Risk reduction: through diversification
- Settlement and custody arrangements are the same as for other classes of share
- Flexibility: being able to adjust an investment portfolio rapidly by investing or disinvesting from a whole asset class
- Transparency: as most ETFs track an index and the underlying assets are widely published, the exposure to those assets is known
- Liquidity: ETFs are highly liquid as they are traded on the Stock Exchange and can be bought or sold throughout the day
- Cost efficiency: there are no entry or exit fees, dealing spreads are tight and management fees are generally lower than those of normal pooled funds
"That all sounds good," I commented. "Are there any disadvantages?"
"There are risks to using ETFs," the investment adviser conceded. "I'll set out the main ones."
- Some ETFs may not track the chosen index as closely as the investor requires, which means returns may be lower than expected
- Small ETFs and those invested in more unusual indexes, such as listed commodities or listed alternatives, may be less liquid
- Certain ETFs are only suitable for short-term investment, and may not perform in the way expected over the longer term
- There are potential tax liabilities on income and capital gains and tax advice should be sought
- Because of the nature of ETFs, additional due diligence and governance should be carried out before entering the market
- If ETFs are bought or sold on a regular basis, this could constitute 'trading' and be in breach of HMRC regulations for occupational pension schemes
"Perhaps the biggest negative," the adviser said, "Is that ETFs don't give investors an opportunity to outperform the market. Although they have their uses, they may not assist trustees with reducing a deficit."
The meeting fell silent again. "So," I said, "A bit like the England football team, they're good but not yet winners at every level."
"Very true and it won't take them long to be winners. One for the future, I suspect," the adviser concluded.
"England or ETFs?" I queried.
"Both!" was the reply.
Written by Simon Riviere, client director, PTL
sriviere@ptluk.com
