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Are ETFs worth the risk?

11 August 2013

The products are cheap and offer instant diversification, but FE Research’s Rob Gleeson says investors should think carefully before committing their money.

By Jenna Voigt,

Features Editor, FE Trustnet

Exchange traded funds (ETFs) have been in vogue in recent years, with major firms such as BlackRock’s iShares and Deutsche Bank’s DBX Trackers launching round after round of the passive products.

ETFs act very much like tracker funds, replicating an index, commodity or basket of assets. However, rather than operating as open-ended vehicles, they are traded like a company on a stock exchange; in this way they are similar to investment trusts.

Trading on a stock exchange means the price depends on supply and demand for the shares; this in turn means that the price can vary from that of the underlying index or commodity.

The products often have much lower charges than actively managed funds, so offer investors the chance to cheaply diversify their portfolios. ETFs also offer the ability to short, or bet against, a particular aspect of the index.


Key advantages of ETFs

1. Diversification – ETFs give investors exposure to a wide market cap spectrum, region or sector depending on the index they track.

2. Lower costs – ETFs carry lower ongoing charges than other investment products, primarily because they are not actively managed.

3. Ease of buying and selling – Because ETFs are traded on a stock exchange, their composition is widely known and they can be bought and sold at current market prices at any point during the day.


However, the products are often criticised for their complexity, raising the question of whether they are a suitable tool for most retail investors.

Rob Gleeson, head of FE Research, believes they can be, but says private investors need to be sure they understand the structure of the underlying product.

"There are two different types of ETF," he said. "Some are physical and some are synthetic."

"The physical ETFs are pretty straightforward tracking funds so it’s easier to know what you’re getting."

"Physical ETFs are suitable for retail investors and they are a low-cost way to track an index, which is good. There are more ETFs than passive funds, particularly for more exotic areas. If you want to track the DAX or emerging markets, ETFs are probably the best choice. You’ll struggle to find a passive fund that tracks these things."

Star equity manager Sebastian Lyon uses a physical gold ETF in his £2.5bn Trojan fund while FE Alpha Manager Bradley George uses a physical platinum ETF in his Investec Global Natural Resources fund.

Gleeson (pictured) warns that investors who are tempted by the returns of synthetic ETFs should take a step back and consider the increased level of risk associated with these more technical products.

"Synthetic ETFs use derivatives, which give them more complexity and often more risk," he said.

ALT_TAG "Because they use derivatives and leverage, all sorts of complexity comes in. Unless you’re confident you understand what you’re doing, it gets complicated really quickly."

He warns the real downside for investors is not realising just how much they can lose.

"As soon as you get more complicated with things like leverage, you can get out of your depth really quickly. Investors often don’t understand the impact leverage has on these funds, so you lose four times as much as you were expecting you could. Investors don’t appreciate where the downside is because it is so amplified."

He points out that because synthetic ETFs employ strategies that are traditionally the domain of professional hedge fund investors, it is worth noting that these products are restricted to private investors to avoid the dangers of being caught out by massive falls on risky bets.

Gleeson says the best way for investors to get access to these types of products is through an actively managed fund where a manager can keep an eye on the workings of more complex investment vehicles.


How to get access to ETFs

Investors can of course access ETFs directly by buying them on the stock market and paying the usual broking fee that applies when purchasing any equity.

However, if investors want access to a broader range of passive products, as Gleeson mentioned, they can go through a fund of passives such as HSBC's World Index range.

Each of the three funds in the rage – Cautious, Balanced and Dynamic – is made up of a combination of index-tracking funds and physical and synthetic ETFs.

The funds have each delivered positive returns since launch a year ago.

As expected, the Dynamic portfolio has gained the most, picking up 15.69 per cent, compared with 12.52 per cent for the Balanced fund and 3.67 per cent for the Cautious one.

The funds have no specified benchmark.

Performance of funds over 1yr

ALT_TAG

Source: FE Analytics

As a point of comparison, each of these products has underperformed the MSCI World index over the period.

They require a minimum investment of £1,000. The Balanced portfolio has ongoing charges of 1.1 per cent, compared with 1.03 per cent for the Cautious portfolio and 1.23 per cent for the Dynamic fund.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.