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Catch of the day

Following on from the success of equity-based, exchange-traded funds, treasurers can look forward to the emergence of fixed-interest ETFs that will help hedge their positions.

Exchange traded funds (ETF) made their debut in Britain three years ago, auspiciously coinciding with the start of the stock market’s decline into the abyss. Unlike individual shares that have taken a terrific beating in the downturn – scaring off institutional and retail investors alike – ETFs have bucked the downward trend, multiplying in number and assets.

Like index mutual funds, each share of an ETF represents the whole basket of stocks in a broad index or a narrow sector (the FTSE-100, for example, or oils). But unlike index funds – shares of which can only be purchased once a day at a price determined at the market’s close – ETFs can be traded all day.

Because each ETF share represents an entire index or sector, investors can gain broad exposure without the risk of buying or selling individual companies. This feature has made them attractive in a bear market, an environment that makes investors wary of picking individual stocks.

“The relevance of these funds is that they are a product that can be used across a broad spectrum, from large pension funds to retail investors,” says Mark Roberts, head of i-shares product strategy at Barclays Global Investors (BGI), one of the largest providers of ETFs worldwide. “Anybody with access to a broker can trade ETFs, and it’s not just about being long or short.

Investors can use the funds whether they’re bullish or bearish on the market, for short-term gain, as a sector bet or to hedge their exposure.” Corporates have shown particular interest in the ETF market as a tool for balancing or diversifying a portfolio, and for hedging and reducing risk.

The feature of a one-trade access for a sector means institutions can use this as a replacement for programme trades. It also represents a significant cost saving for the investor who doesn’t have to administer a basket of shares.

The ETF market got its start in the US about 10 years ago as a common sense response to the axiom that in a bull market, investors want to own big winners, but in a bear market, they don’t want to own big losers. Unlike individual shares that cannot be sold short when their prices are falling, short-selling ETFs is allowed in a downturn. The fact that ETFs are not subject to short-sale rules helps to account for their success and is one of the reasons they are popular with hedge funds.

Last year, global ETF assets under management increased by 35% to $141.6bn, with 280 ETFs listed on 26 stock exchanges worldwide. The UK market was about £1.5bn at the end of last year, generating a trading volume of 3.5 million shares a day on the London Stock Exchange. Fifteen ETFs are currently available in the UK, of which 14 are Barclays’ i-shares, ranging from an auction type FTSE-100 fund to eight pan-European sectors.

This is not about magic wands. ETFs have suffered along with all other types of investment vehicles in the last three years – only less so. For instance, £10,000 invested on 1 December 2000 in an ETF tracking the FTSE-100 would have been worth a little more than £7,100 two years later. Grim, but not nearly so much as the same amount invested in a unit trust or OEIC investment based on the same benchmark and investment period, which would have left about £6,800. This 3% difference, amounting to £300, becomes more relevant when it is raised to the power of millions for pension funds and other institutional investors.

Typical charges for unit trust or OEIC investments tracking the FTSE-100 can range up to 1.4% annually, well in excess of the ETF charge of as little as 0.35% on an annual basis. Investors in ETFs are also not required to pay stamp duty on secondary market transfers, as the shares now listed on the London Stock Exchange are registered in Ireland and therefore exempt.

ETF watchers are forecasting strong growth in the number and diversity of funds this year, although an industry shakeout is likely to prune the number of products on offer. Analysts are talking about a doubling of the market in the coming months, with a dip in the number of products that will be offset by the entry of new funds.

The problem is going to be providing investors with innovation. In the US, the Securities and Exchange Commission is already reviewing one company’s filing for leveraged ETFs that aim to profit when their underlying indices rise by providing twice the daily performance of those benchmarks. “It’s going to be hard to come out with something new and different, but we’re starting to see it with fixed income and leveraged funds,” says Kevin McNally, head of ETF research at Salomon Smith Barney.

Fixed income looks like the coming trend in ETFs. “We are developing a broad family of credit markets,” says Roberts. “This would allow treasurers to manage or hedge their credit exposure. We plan to bring out (some) sterling-based funds along those lines.”

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