Exchange traded funds offer many benefits, including low costs, simple trading and greater access to a wide choice of strategies and markets – especially useful in troubled times.
Exchange traded funds (ETFs) and exchange traded commodities (ETCs) provide simple diversification tools, while allowing all investor types to access markets and investment strategies previously only available to sophisticated investors – especially useful in turbulent times. In addition, active managers fail to consistently beat the market. Therefore, investors may be better off investing a large portion of their assets in passive index trackers like ETFs and ETCs.
ETFs are similar to mutual funds but are traded continuously on a stock exchange. These products have made a huge impact on investment and portfolio management since their inception in the early 1990s. Assets are approaching $1,000 billion (£500 billion) across 1,000 ETFs globally, and there are listings on about 50 stock exchanges.
ETFs initially covered the asset classes of equities and fixed income, but now cover alternative asset classes such as real estate, currencies and commodities. With these asset classes covered by a variety of ETFs, a diversified portfolio can be constructed in as little as four or five easy transactions.
The funds were developed for several reasons, but their first big advantage was to provide easy access to mutual funds, which provide portfolio diversification benefits in a single trade. By trading intra-day and not at day-end prices like mutual funds, investors could use ETFs to take advantage of daily market movements and for hedging.
Now ETFs are being created to provide all investor types with access to investments that were not available though domestic brokerage accounts – commodities and emerging markets for example. In addition, sophisticated strategies such as shorting (allowing investors to profit from falling prices) and leverage (the ability to invest with half the capital) are available through ETFs.
Until the advent of ETCs in 2003, commodity markets were the realm of producers and “sophisticated” institutional investors only – either through buying the physical commodity, trading futures contracts or negotiating bespoke long-term agreements. Initially liquidity was low, but now commodities trade about $100 billion a day. In addition, commodity markets used to be heterogeneous, opaque and small. Today, commodities markets have become regulated, transparent and liquid. This makes commodities suitable for investment and securitising.
Research has shown that commodities can benefit a portfolio because of their low correlation with equities. This is not surprising since the factors that drive commodity prices – such as supply-demand, weather, technology and discovery – are specific to commodities. In addition, commodities form the ingredients of most goods and products. Therefore if the world and emerging economies are to grow, demand for commodities will always increase.
The graph shows the growth of the global ETC market, which was initiated by the gold ETC in 2003. In the past two years alone, global ETC assets have grown by more than 1,000%, with the number of products increasing from about 10 to more than 80. ETCs have been listed on most of the world’s prominent stock exchanges and cover every big commodity group. Global ETC assets are likely to reach $50 billion by December.
ETFs and ETCs have several benefits. First, they are exchange listed and a variety of asset classes can be held in ordinary brokerage accounts and self-managed pension funds. They also provide a single market. Cash, currencies, emerging markets, commodities, equities and shorting strategies can all be accessed in one timezone and on the same exchange.
The funds are simple and do not require any daily operational management such as storing commodities, managing futures positions, borrowing stock to short, rolling or margin calls. They are also cost effective. Because of their passive and simple nature, costs are low and transparent. In addition, wholesale prices are made accessible to all investor groups. Lastly, ETFs and ETCs can be used for asset allocation, core and satellite approaches, cash equitisation, sector and style allocation and rotation, and risk management.
Emerging markets are much more accessible through ETFs. Previously, high international transaction costs, trading out of hours, investment restrictions and the unfamiliarity of foreign markets were barriers. Emerging market and frontier markets will become more popular through ETFs, especially if an American slowdown is experienced alongside continued GDP growth in emerging economies.
The choice of ETCs is also expected to increase, with more short and leveraged ETCs launched. New commodity indices, rolling strategies, commodities and global commodity company sectors will also be launched in 2008.
Within cash and currencies, the most liquid markets in the world are still expensive or hard to access for the average investor. This market will continue to expand, providing investors access to wholesale money markets such as the London inter-bank offered rate (Libor) and the Euro Overnight Index Average (EONIA), and currency markets such as Asian and Latin American foreign exchange.
The development of quantitative and behavioural financial models have enabled the creation of active investment strategies through passive investment structures. This market will also expand as new ETF structures develop to accommodate new active strategies.
Now that short and leveraged ETFs and ETCs are available, this space will increase rapidly. As a result, short, leveraged, capital protected and currency-hedged ETFs and ETCs should make it on to the world’s stock exchanges over the next 18 months, making these investment strategies available to all types of investors. In times of volatile markets, these strategies may be particularly useful.
In conclusion, investors have access to a range of diversified tools that can protect portfolios against falling asset prices.