Exchange traded funds take off as Britain plays catch-up

Exchange traded funds (ETFs) listed on the London Stock Exchange (LSE) have more than doubled in number this year. Last month they reached 100, compared with 46 listed at the start of 2007.

One reason for this growth is the change in stamp duty rules in March. Previously, non-resident ETFs were charged stamp duty for listing in Britain, which discouraged offshore providers from entering the market.

Now that the duty no longer applies, could we see a boom in the British ETF market? We could, according to Dan Draper, head of ETFs UK, Ireland and Nordic at Lyxor Asset Management. “The UK is playing catch-up,” he says. “London has great potential as a global ETF centre. An ETF is a good tool to get exposure to a market, whether it is equities, bonds or commodities. It is transparent.”

ETFs are baskets of securities that can be traded like equities on a stock exchange. They provide a cheaper way of gaining access to a market than a traditional mutual fund, and the fact that they can be traded and offer real-time dealing gives investors greater liquidity than a traditional tracker.

ETFs offer access not only to the core indices, such as the S&P, FTSE 100 and the Eurofirst 80, but also to specialist areas such as alternative energy, soft commodities, water and steel. Anything that can be tracked, whether it is a core index, a sub-sector or type of commodity, can have an ETF based around it.

Barclays was the first to list an ETF in Britain with its iShares FTSE 100, registered in 2000. There are now more than 50 iShare ETFs listed on the LSE. Lyxor Asset Management has more than 20 ETFs listed in Britain, including Brazil, China, India, Japan and Russia ETFs. Deutsche Bank has at least 15, while Invesco PowerShares listed eight last month. The most recent additions come from ETF Securities, which listed four ETFs last week that invest in commodities, including live cattle and natural gas.

The liquidity and transparency of ETFs are among their strongest selling points, according to providers. Because they track an index, they are fully transparent: investors will know at any given time what they consist of. Also, investors can move in and out of them with ease. Such liquidity has attracted hedge fund managers to use ETFs as short-term alternatives to cash to avoid a cash drag on performance. But the hedge fund community is not their only market. In fact ETFs, unlike most financial products, are claimed to be suitable for all investors, whether institutional or retail.

The benefit of not having to monitor individual stocks or, more importantly, the potential of extreme highs or lows in their performance, will be an appealing thought to some.

According to one source, a fund manager put his entire fund’s assets into an ETF as a way of safely tracking the fund’s benchmark while he was on holiday.

Indeed, the ease of buying in and out of ETFs has already taken hold in America and Europe, where the markets for these products are far more advanced than in Britain. In Europe there were 386 ETFs at the end of September, with assets under management of €386 billion (£276 billion). In America there were 533 with assets under management of $530 billion (£257 billion). Morgan Stanley predicts that the global ETF market will grow to $2 trillion in assets under management by 2011.

Draper says the real growth area is in emerging market and alternative investment ETFs. Lyxor offers 104 ETFs globally. Of those it lists in London, 12 are emerging market funds. Lyxor plans to launch more such ETFs, especially funds focused on Asia, early next year.

Hilary Coghill, chief investment officer at City Asset Management, says she likes the specialisation that ETFs can offer. She is looking closely at the Invesco Powershares Global Clean Energy portfolio.”[ETFs] are becoming increasingly interesting,” says Coghill. “The new ETF from Invesco is quite a specialised one. It is a niche area. We are considering using that.”

However, Coghill is cautious of using core ETFs, especially in current market conditions, where she says there is an increasing divergence between stocks that perform and stocks that do not. “At the present time I’m not sure I’d want an ETF in the [FTSE] 250,” she says. “[Instead] you want a strong stockpicker because of the divergence between those that have performed and those that have underperformed.”

It is the cost-effectiveness of ETFs and the specialist areas they can open doors to that appeal to Coghill the most. “For getting exposure it’s increasingly more economic to use them,” she says.

Williams de Broë was one of the first British firms to use ETFs, and, like Coghill, Jim Wood-Smith, head of research at the firm, says cost efficiency was the main attraction.

“ETFs were a significant step forward from the indextracking unit trusts that were around at the time, where you were paying a fund manager with varying degrees of success and failure,” he says. “ETFs were a much more cost-efficient way of tracking an index. The derivative-based structure, miniature cost and real-time dealing meant they answered all the problems. They are liquid, tradable and have real-time pricing – everything you would want from this kind of thing.”

Again, like Coghill, Wood-Smith finds the specialist areas covered by the ETF market particularly attractive. “It has opened up areas for the retail client that would otherwise be completely off the radar screen,” he says.

“ETFs are a useful part of tactical asset allocation. If you take a macro view that technology is a good area to be exposed to, a quick and easy way [of doing that] is to buy a Nasdaq index tracker, for example.

“Ease of dealing is a key point. If you believe in one’s skill as an asset allocator, ETFs are your made-inheaven solution.”

However, Wood-Smith offers a word of caution to investors. He says the appeal of more specialist markets could go to people’s heads. “The more esoteric ETFs become, the more buyers are tempted to stray out of their core competencies,” he warns. “It is not a one-way street. There are dangers.”