DIY Investor Magazine
/
March 2014
10
BY BEN THOMPSON
DIRECTOR, BUSINESS
DEVELOPMENT, LISTED
PRODUCTS & LYXOR ETF
CONSTRUCTING AN ETF PORTFOLIO
Exchange Traded Funds, or ‘ETFs’ as they are known,
are leading the charge in a new democratic world of
investment where investors are increasingly taking
charge of their own portfolio.
Why? Firstly because they are simple to trade. Just like
regular shares, ETFs can be purchased through a UK
stock broker using a share dealing account, ISA or SIPP.
The second reason is diversification. ETFs are
intrinsically diverse. For example, instead of building
your own portfolio of UK equities, and paying costs
and fees on each one, you can purchase a single ETF
that provides exposure to the top 100 UK companies
through the FTSE 100 Index.
Not only are the vehicles themselves diverse, but
with a product range spanning different market
sectors, regions, themes, commodity baskets or fixed
income strategies, and the whole risk spectrum from
government bonds to single country emerging markets,
ETF investors can easily create a well diversified core
portfolio. Furthermore, with both income paying
(distributing) ETFs and growth (capitalising) ETFs
available, they can capture both growth and income.
ETFs can also be used tactically to take advantage
of short term trends. The combination of core and
satellite allocations means that investors can build a
portfolio to suit their specific views and investment
budget. Small portfolios can be built with a handful of
ETFs, and larger portfolios with very specific exposures
can achieve even greater diversification. The third
major factor is cost. Unlike actively managed funds
where you are buying the skills of a ‘Manager’, with
ETFs you are simply buying a passive investment that
tracks a benchmark index.
As such, ETFs are significantly cheaper and Total
Expense Ratios (TERs) typically range between 0.15%
and 0.85% per year. This TER is the annual charge that
includes costs such as custody fees, marketing costs
and index licensing costs. On top of this, investors will
be charged a brokerage fee in the same way as when
buying shares. Importantly though, the TER is not a
true measure of the Total Cost of Ownership (TCO).
Although all ETFs share the same aim – to track an index
as cost effectively and precisely as possible – some do it
much better than others. Tracking difference and tracking
error are two measures that describe how precisely and
consistently the ETF tracks its benchmark. As anything
less than the index performance is a cost to you, it is
important to look at these variables. The bid/ask spread
will also impact performance as the difference between
buy and sell price is key to your trading cost.
As with any investment product, ETFs carry a number
of risks. Most ETFs are index tracking funds, meaning
the performance of an ETF will rise and fall with the
underlying index which may be complex and/or volatile,
exposing investors to market risk. Investors’ capital is
at risk, and you may not get back the amount originally
invested.
Investors may be exposed to counterparty risk resulting
from the use of securities lending in physical ETFs, or
from the use of an OTC performance swap with an
investment bank for synthetic ETFs. If the index or the
constituents of the index are denominated in a currency
different to that of the ETF, investors are exposed to
currency risk from exchange rate fluctuations.
TRACKING
DIFFERENCE
How close is the performance
of the ETF to the Benchmark?
How accurately does the ETF
track the Benchmark Index?
What is the spread between the
Buy (Ask) price and sell (Bid) price?
TRACKING
ERROR
TRUE
PERORMANCE
LIQUIDITY
