Fool's Eye View

[ April 19, 2000 ]

i Spy with My Little Eye

By James Carlisle (TMFJimmyC)

Something beginning with i. Just one at the moment, although there will be more in due course. Have you got it? It's the new iFTSE100, launched today by Barclays Global Investors (BGI). What, I hear you ask, is an iFTSE100 when it's at home? Well, that's easy, it's an iShare which, in turn, is an exchange traded fund (ETF), so I'll start by having a look at these.

Exchange Traded Funds

ETFs are a slightly unusual type of index tracker. They were originally introduced in 1993 with the SPDR (AMEX: SPY), or "spider" for short. Spiders track the S&P 500 index in the US. For a variety of reasons (which I'll come to), they have been hugely successful and the total spiders in issue are currently worth $15.4 billion. This has led to a whole range of ETFs tracking various markets and sectors. The best known after the spider is the "cube", or QQQ (AMEX: QQQ) which tracks the Nasdaq and is valued at a total of $9.2 billion.

ETFs can be thought of as a cross between shares in a "closed-ended" fund (that is, an investment trust) and the units in an "open-ended" fund (that is, a unit trust). To you or I, they appear closed-ended, like an investment trust. You buy and sell them through a stockbroker just as you would any other shares. However, to a large financial institution, they appear like an open-ended fund. This means that they can go along with a pile of cash and get them swapped for the ETFs. They can also go along with a pile of ETFs and get them swapped into a pile of cash. In fact, the institutions have to swap the ETFs for the underlying shares in their relevant weightings in the index, but the institutions carry plenty of these in stock (as they are trading them all the time) so it's pretty much like cash to them. What makes ETFs special is that the institutions can do all this at net asset value. The effect of all this, say the ETF proponents, is that you get the best of both worlds.

Unit trusts have to deal with the costs involved with private investors coming along with a few hundred (or thousand) quid and asking for new units to be issued (or asking for existing units to be redeemed for cash). This can get pretty expensive. ETFs, like investment trusts, avoid these costs because all the creating and cancelling of them that goes on is done in serious bulk.

The trouble with investment trusts is that they are seen as being more risky than open ended funds, since their share prices don't necessarily follow changes in the underlying net asset value (in the case of trackers, the index). Instead, they simply follow supply and demand. This means that they tend to trade at a discount to net asset value. ETFs get around this problem by allowing the institutions to come along and cash then in at net asset value. As a result, if their price ever gets very far below the underlying value, our Wise friends in City will come along and do just that.

The above process has enabled the spider to have an average discount of only 0.02% (presumably representing the tiny cost to institutions of doing the share swaps) and charges of only about 0.2% per annum. This would, indeed, be very hard for an investment trust or unit trust to match. However, it has taken the spider a few years to achieve these economies of scale and it will take a while for any new ETF to match this performance.

The iFTSE100

The iFTSE100 will, you will not be surprised to hear, track the FTSE 100. When iShares were originally announced, I wrote in a personal finance article that I hoped that they would track the FTSE All-Share, because of the extra diversification. However, looking at things more closely, this was a little unrealistic. ETFs work by fully replicating the underlying index which they track. On this basis, tracking the FTSE All-Share with its 800 or so stocks (some of which are highly illiquid) would either be too expensive or impossible. The FTSE 100 accounts for 80% of the FTSE All-Share, so it shouldn't actually matter too much. Some of the arguments about which index is best to track are given in the articles linked to at the bottom of this page.

The iFTSE100 will be available from Friday 28 April 2000 and can be bought, just like normal shares, through a stockbroker. The annual management charge will be just 0.35%. It is expected that brokers will run schemes to allow regular savings into them and to put them into an ISA. The trouble with this is that its likely to cost extra and it is likely that the cheapest tracking unit trusts will continue to provide the obvious solution for regular savings into tracking ISAs. However, the low charges of 0.35% leave some scope for extra charges and for those that want full replication of the FTSE100, this should probably be as good as most. For people who want to deal in lump sums and don't necessarily need an ISA, iFTSE100s will stop them having to subsidise those that do do regular savings in an ISA.

One other benefit is that investors will not have to pay stamp duty to buy iFTSE100s. The market makers will have to pay it when they create new units, so the benefit to investors isn't complete. However, because the trading of already created units will not incur stamp duty, it is expected that their bid/offer spread will, to some extent, take this into account. The upshot is that the spread on iFTSE100s should be less than the spread on the underlying shares in the FTSE100.

iShares in general and the iFTSE100 are welcome additions to the Fool's armoury of cheap trackers and it will be interesting to see them develop.

Related Links
• Fool's Eye View discussion board
• iShares Website
• iShares - A New Breed Of Tracker
• How Do Index Trackers Work?
• Which Index Trackers Are Best?
• Investment Trust and Unit Trust Basics