Exchange-traded funds become investment of choice for many

More than 95 per cent of respondents to a survey of US investors carried out last year by investment bank Charles Schwab said they considered exchange-traded funds (ETFs) a necessary part of their investment strategy, while 91 per cent of them described them as their investment vehicle of choice.

And little wonder: ETFs are the favoured investment instrument of the passive investor – those who are content to match market performance rather than beat it. Active management strategies, on the other hand, tend to entail high fees and charges for investments which all to often fail to deliver on expectations.

They are also relatively simple for an individual investor to understand. The funds track the performance of a stock-market index or other asset and the investor gains or loses in line with that. For example, an ETF based on the performance of the Irish Stock Exchange (ISEQ) would offer returns based on the ups and downs of that index.

Over the past year an investor in such an ETF would have seen their investment shrink by about 18 per cent. On the other hand, if they had invested in January 2014 they’d be about 26 per cent to the good.

"As a disruptive investment vehicle, the inception of ETFs has given retail investors access to asset classes which were previously beyond their reach," says Paul Heffernan, head of cross-border sales, Europe, with HSBC Securities Services. "In addition, ETFs trade on the stock market, which allows investors to take advantage of daily fluctuations of a selected index. ETFs are highly accessible as while they are managed similarly to a mutual fund they do not require a minimum amount to start trading. Another advantage to ETFs is the lower trading commissions offered, which allows investors the opportunity to create a portfolio of shares in a group of related companies as a single purchase."

It is forecast that within the next few years, almost all asset managers will offer ETFs, Heffernan adds. “With Ireland attracting over 50 per cent of European-domiciled ETFs, understanding the potential of ETFs is vital for asset managers based here.”

Benefits

Gayle Bowen, investment funds partner and head of office with Pinsent Masons Dublin, sums up the main benefits of ETFs as lower costs, increased liquidity, improved transparency and market access. “They are cheaper to operate than conventional funds; they offer intra-day trading, which conventional funds do not; they list all the underlying securities, so investors know exactly what they are invested in; and they can provide investors with access to markets that they could not invest in otherwise.”

She also notes an important difference in the way these funds can operate. “ETFs can track an index in two ways, either by directly purchasing the underlying assets that are comprised in the index or synthetically, by replicating the indices using derivative swaps contracts instead of directly holding the underlying shares. The main advantage of the synthetic route is that it is quicker to track an index via a derivative contract and this reduces tracking errors, as it takes longer to buy and sell shares directly. It is also cheaper as you do not incur trading or broker costs. However, where using derivatives, there can be increased leverage and margin risks.”

While HSBC is active in the ETF space, Heffernan points to the continued importance of active investment strategies. “We must recognise an intrinsic need for balance between passive and active fund management. Efficient portfolio management suggests that the market needs active management, where a fund manager attempts to beat the market with various investing strategies. Moreover, a future with a large majority in passive strategies could create significant market disruption, leading to a point in which active would be enticed back as a result of new opportunities presenting themselves.”