Do exchange traded funds stack up against traditional open ended funds?
For all my interest in exchange traded funds I admit that I've come to them relatively recently -- a mere 18 months ago.
Having said that, I was a swift convert to the concept and I've been using them increasingly. However, everything is relative when it comes to investing so it's a good idea to step back from the investments you find most engrossing and compare them with other options.
The obvious alternative to ETFs is the open ended investment funds, for the comparable regulatory protection they offer but also for the far greater choice that's available.
The power of tracking
ETFs have scored well among passive investors because index tracking was an intrinsic feature of these funds right from the beginning.
Of course, there are also unit trusts and OEICs that track indices, but they're a small minority of these funds and the literature on building complete portfolios from open ended tracker funds is small. HSBC and Legal & General both cover several developed equity markets with their tracker funds, but overall the choice of open-ended trackers is poorer by far than the choice of tracker ETFs.
Moreover, while some managers, such as HSBC, already have expenses that compare well with ETF expense ratios, generally OEICs/unit trusts still don't stand comparison with the exchange traded sector on this count. The degree to which this is set to change -- as a result of competition from ETFs and also the arrival of Vanguard funds in the UK, is still to unfold.
Not only do ETFs enable investors to track equities but they also open up other asset classes for tracking, especially fixed income but also some commodities. That said, just because ETFs are good for equity index tracking could make them a snare when it comes to other kinds of index.
The commodities futures indices that most exchange traded commodities (ETCs) track are a case in point; they should come with a health warning and require careful research. And short and leveraged ETFs and active ones look like as if they may be ways of taking a good idea and spoiling it, and possibly damaging the reputation of ETFs collectively into the bargain.
Regulatory requirements
I'd always recommend understanding the index you plan to track before investing, but there's no more cause to be dubious of ETFs as a class than open-ended investment funds.
From the point of the level of regulation they face, the two types of investment are on an equal footing. ETFs' reputation seems to have suffered because they're new and some investors have lost out when new types of fund -- such as split capital investment trusts or hedge funds -- have been sold to them.
In particular, swap-based ETFs -- ones where the fund's returns are guaranteed by a swap counterparty -- have aroused some unnecessary suspicion. The facts are that EU regulation limits investors exposure to the risk of a counterparty failing to 10% of the value of the fund and swap-based ETF sponsors such as db X-trackers reduce exposure to swap counterparties to much lower than that percentage.
Of course, investors can lose a much larger proportion of their original investment but the risks relate to the assets they choose to track, not the swap counterparty.
Will ETFs keep their advantage?
Up until now, ETFs have compared favourably to open ended funds because they are a good way of tracking equity indices. Another way to look at ETFs is to see them as investment vehicles used by institutional investors, whose involvement is key to keeping expenses down, but regulated for private investors benefit like open ended (retail) funds.
The problem for ETFs, and the private investors who buy them, is that it looks like that ETF proliferation could lure people away from the basic ETF models that are serving them well into altogether more arcane indices and riskier investments. At the same time, more tracker open ended funds and lower expenses for the open ended category as a whole could eat away at the ETF advantage substantially.
There are two final considerations in weighing up the relative advantages of ETFs and open ended funds.
Firstly, the matter of all day trading, which some might view as the ETF's definitive characteristic. For frequent traders this may be the clinching argument in favour of ETFs. Clearly all day trading is essential in attracting institutional investors' interest but, personally, for private investors it seems more of a temptation than an opportunity. If I change my mind about which ETFs to hold too often, I quickly lose on trading costs what I saved on expenses.
Secondly, in terms of marketing and promotion, are open ended funds and ETFs doomed to become indistinguishable? Quite possibly; the number of fund managers who offer both, such as HSBC, Vanguard and BlackRock, is on the increase. But it will be a shame if this happens, because ETF sponsors have generally done a much better job of explaining how they work than fund managers have done with conventional funds.
As the best model for do-it-yourself investing yet, ETFs have shone a light into areas such as exchange risk, liquidity risk and sovereign risk that fund managers would far rather investors didn't worry about. I surmise a lot of this new-found information could be at risk, if ETFs came to be marketed as merely a variant of the open ended fund.
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