The truth about trackers

Some European investors fear Exchange-Traded Funds because the full advantages have not been explained.

Exchange-Traded Funds (ETF) are index-linked products that are continuously priced on an exchange. The first ETF or tracker fund was created in 1993. The S&P 500 SPDR, managed by State Street Global Advisors (SSgA), is the number one ETF worldwide with more than $30bn in assets under management. There is a large array of ETFs covering several of the best-known indices. From large cap to small cap, from country indices to MSCI World, these tools are available to offer a proper allocation depending on the chosen investment goal and risk tolerance. In Europe, the growth has been impressive: in 2001, 70 ETFs have been listed across Europe for a total of E4bn. The index of reference is either domestic (for example, the streetTRACKS AEX Index ETF), regional (for example, the streetTRACKS MSCI Pan Euro ETF) or sectorial (for example, the streetTRACKS MSCI Europe Sectors ETFs). Usually, ETFs are managed by professional firms that have an extensive knowledge of index management. Unlike classic mutual funds, ETFs are priced continuously, reflecting the weighted average price of the index’s underlying securities. This implies that investors can buy or sell at any moment, gaining instant exposure to the markets. There is no need to wait for the end-of-day net asset value (NAV) to know at what price a fund can be bought or sold. The price paid is the price of the market. The spread is usually low (a 10-50 basis point range) and is maintained by the largest brokerage houses. Being on an exchange, continuous competition exists and if a spread deviates too much from the fair market value, broker dealers will proceed to arbitrage, bringing the cost back into line. Application Units of ETFs, like shares, are available on exchanges. The market is supported by market makers or liquidity providers, who have the contractual obligation to provide units within a spread imposed by the exchange. One of the least known aspects of ETFs is their liquidity. Some of the funds do not have a large on-exchange volume. This apparent lack of liquidity put some investors off investing in them because of the fear of not being able to get out of their positions. What these investors do not realise is that ETFs allow market makers to either redeem or create units on demand with the asset manager. ETFs are characterised by two parallel markets, referred to as primary and secondary markets. Each morning, the manager of the fund will provide the NAV and the composition of the fund (basket) to the market maker and to the exchange. Based on the composition file, the market makers and brokers/dealers will recalculate the value by taking the weighted price of each security as if they had to buy it. Throughout the trading day, the value will be adjusted based on the individual share movements and continuously sent to the exchange. The latter will also calculate an indicative value based on the movement of the index. The bid/offer spread, which is usually tight, represents the trading costs, taxes and the individual spread on each security in the basket. If a broker needs to deliver units to a client, they will check what is available on the secondary market (the exchange). If the demand is high and if other brokers do not have enough units on their books to provide the necessary shares, the market maker will undertake a creation process. To do so, they will deliver a perfect basket of shares to the manager, who will provide a given number of units in exchange, usually 50,000. The broker will either deliver the units to the client or keep them on their books. This mechanism ensures perfect liquidity because units can be created on demand in delivering stocks, which are among the most liquid in the equities market. The reverse process will be applicable in the case of redemptions. Benefits ETFs are inexpensive and transparent. The average total expense ratio of trackers in Europe is 0.5 per cent annual (versus an average of 1.5 per cent for classic mutual funds). They do not carry any hidden costs nor entry or exit fees. The only additional charges will be the broker fees, as with any ordinary stock. This makes the ETF a perfect tool for a wide array of investment techniques. Strategis

• Core satellite portfolio using sector or country trackers. ETFs make tactical asset allocation flexible and efficient. Using a regional ETF like the streetTRACKS MSCI Pan Euro as a core and streetTRACKS MSCI Europe sectors as satellites allows the implementation of efficient sector based strategies.
• Active trading. Investors are aware that adequate diversification helps to reduce risk. Trackers are a credible and efficient answer. They allow sector exposure without the risk of a single stock. Their flexibility and versatility allows the investor to build strategies with the goal of outperforming the index, while keeping the diversification of the underlying stocks. Stock picking is risky and sector index ETFs are a wise answer to volatile market conditions. This is also true for other country or regional ETFs, where the use of index techniques ensures diversification without active risks.
• Hedging. In volatile markets, hedging techniques are widely used by institutional investors and less widely by individual investors. Derivatives have often been chosen to protect portfolios against adverse price movements. ETFs can be just as effective. Like ordinary shares, they can be shorted to offset potential market or sector losses and then provide an efficient answer to downside market risks. This will be when the asset allocation and tactical choices are made in a region or sector where it is not possible to find corresponding derivatives. Depending on the investment horizon, the use of futures can have additional administrative and financial costs above those of ETFs.
• Cash equitisation. ETFs allow investors to “park” their excess cash pending final allocation. One single transaction brings instant exposure to hundreds of stocks. Being highly liquid with low cost, ETFs allow professional and retail investors alike to be exposed to the market for the length of time they need without any formal commitment.
• Intra-day trading. Classic mutual funds are usually priced once a day, at the close of market. In volatile markets, investors can either take a full day loss or lose a full day increase with the inability to interact directly with the market. ETFs allow investors to act efficiently in all market conditions, enabling them to have full control of their investments. If all these techniques can be implemented with single stocks, the power of ETFs as diversified portfolios helps make risk management easier and allows sector exposure without the risk of single stocks. The power of diversification is one of the foundations of modern portfolio theory. The use of ETFs provides the reduction of risk at the individual fund level and the combination of sectors and country funds allows the investor to build an efficient portfolio by leveraging the diversification. Success ETFs bring a new array of opportunities to the European market. They combine the advantages of index funds and the flexibility of single stocks. And the availability of transparent and well-built MSCI Europe sector funds provides a wide choice. ETFs are simple products but they need to be explained in detail to appeal to all investor audiences. This is the responsibility of all parties involved in ETF creation: the fund sponsors, the exchange, the broker dealer community and the index provider. Making this product known will be the best route to success.