ETFs: An extra layer of UK protection

Despite confusion over a mention in the Autumn Statement, ETFs are an important investment tool

I nearly spat my tea out when George Osborne mentioned exchange traded funds in the Autumn Statement. There were the usual announcements on economic growth and tax changes but I was not expecting ETFs.

After initial confusion (even a few experts were discomb- obulated) it soon emerged the Government is wiping off stamp duty from ETFs based in the UK from April. It seemed trivial at first. “Who cares, there aren’t even ETFs based in the UK!” the naysayers cried.

Well, that is exactly the point. Until now, many of the ETFs that UK investors buy are domiciled in Dublin or Luxembourg. They are not based in the UK because otherwise savers would be charged stamp duty when buying shares in the fund.

Two layers of tax

To clarify, there are potentially two layers of tax – and this is where confusion stems from.

At the fund level, a UK-based ETF would incur stamp duty. This is being abolished. So even though there are no UK ETFs, this change allows them to be launched without this punitive tax treatment. At the underlying investment level, an ETF investing in UK shares incurs stamp duty. However, this is not paid by the investor, but the fund manager. So as far as investors are concerned, they have never paid stamp duty on ETFs.

Why would investors bother buying UK-domiciled ETFs, then, if they are exactly the same as existing products other than being based at home?

As Adam Laird, a passive investment manager at Hargreaves Lansdown points out, it will mean investors get covered by the FSCS. “If more ETFs are based in the UK, it introduces more options for investors,” says Laird. “Investors prefer to buy a product based in the UK – knowing it is being regulated by the FCA and covered by UK compensation schemes.”

Although to date no ETF has ‘blown up’, it is comforting to have this extra layer of protection. So, if fraud meant ringfenced ETF assets went missing and the company went bust, then FSCS cover would come in handy.

And if more ETFs are launched in the UK, competition will apply further free-pressure and could see costs come down even lower.

Indeed the fee war is intensifying in the ETF arena, especially since Vanguard launched its range for UK investors in 2012.

Hargreaves has also secured low pricing on trackers, offered by BlackRock and L&G.

These changes come at a time when there is soaring interest in ETFs in the UK. Despite slow uptake when first launched back in 2000, assets in ETFs have mushroomed, especially since the 2007 crisis. ETFGI data shows assets across Europe now sit at $400bn, from about $130bn in 2007.

And interest is on the up. Laird says: “The DWP has put the focus on cost in auto-enrolment pension schemes. Low-cost passive products like ETFs are going to be on more investors’ radars and clients want reliable investments based from the UK.”

At the same time, the implementation of the RDR and the consequent focus on charges and commission casts a shining light on ETFs – which are low-cost and have never paid trail.

This should not be viewed as an endorsement of the archaic and flawed active versus passive argument. Although it is the case passives are garnering more interest and some active funds, under cost and performance pressure, are losing money, there is more of a polarisation taking place, where the best active funds are getting bigger and investors are then turning to low-cost passives in certain asset classes.

But, despite increasing interest for ETFs in the UK and this advantageous tax change, it’s unlikely there will be an instant flood of UK-domiciled products launched come April.

One city expert said as product providers domiciled in Ireland or Luxembourg do not pay stamp duty, this tax change is unlikely to lure major ETF providers to the UK.

Still, the passive investment arena is rapidly expanding and the UK is opening its doors to take advantage of this. There will no doubt be much hype surrounding the first UK-domiciled ETF when it launches.

For Osborne, it will help UK Plc, by bringing in business. And for investors, it’s another, improved tool in the investment tool box.

ETF Graph Feb 2014

Key takeaway

Stamp duty on buying shares in UK-domiciled ETFs is being abolished from April. This paves the way for investors to get domestic ETFs with protection from UK compensation schemes.