Hedge funds have been getting most of the headlines recently, and not necessarily for the happiest of reasons. But there is another type of investment that is quietly taking off: the exchange traded fund (ETF).
In the past, investors were faced with a simple choice: either they put their money in actively managed mutual funds with hefty fees and no guarantee of performance, or they could buy an individual company share with all the attendant risk.
But the arrival of ETFs has given investors a third option. Now, they can invest in specific sectors of the stockmarket, or into certain geographical areas, with much lower management fees than conventional funds and less chance of significant tracking error.
The first ETFs came into being in the US in 1993 and were benchmarked against the S&P 500 stock index, probably the most relevant index for investors seeking a representative snapshot of the health of the US economy. These proved so popular that a raft of new ETFs soon followed. The Dow Diamonds, benchmarked against the Dow Jones Industrial Average, was created in 1998, followed by various specific sector ETFs.
ETFs have become increasingly popular with investors disillusioned with the cost and performance of actively managed funds. Investors like the fact that ETFs have lower expense ratios, are more tax efficient and more flexible than funds. But ETFs aren’t so popular with financial advisers, who have little opportunity to earn big fees from them.
Many market participants find ETFs a great way to achieve low-cost portfolio diversification, both for the passive and more actively inclined investors. Indeed, hedge funds are major buyers of ETFs. So ETFs offer a user-friendly way for the little guy to play on a level playing field with the City and Wall Street professional.
ETFs worth buying
The ETF market remains primarily US-focused, but international varieties are being introduced. For my money, two of the most interesting are the Russell 2000 Value Index Fund (IWN) and the S&P Small Cap 600/Barra Value Index Fund (IJS). These will appeal to investors wary of the valuations of larger capitalised stocks and looking for value, rather than growth.
Another fund with a bias towards value, rather than growth, is the Dow Jones US Utilities Sector Index Fund (IDU). Readers going for higher income should look at the Dow Jones Select Dividend Index Fund (DVY).
Regular MoneyWeek readers will be familiar with the pros and cons of the resources sector. Resource market bulls could consider the Goldman Sachs Natural Resources Index Fund (IGE), or, for gold in particular, the iShares Comex Gold Trust (IAU). For those who believe in the oil story, Oil Service HOLDRs Trust (OIH) is worth considering.
There are also a number of bond-related ETFs. One particular low-risk version – a good idea, given that the debt markets could well be unsustainably expensive Â- is the Lehman TIPS Bond Fund (TIP), which offers exposure to a full range of US government inflation-protected notes.
The ETFs to go for next
Look at a sector like China and you’ll probably end up with a ‘demanding investor wish list’, says Rob Mackrill in The Zurich Club CommuniquĂ©. What with oil, telecoms, and financial services, there’s a lot to choose from. But that’s where ETFs really come into their own. Value for money is a serious advantage, as is flexibility, but what is ‘truly impressive about ETFs is their track record’.
Only seven of the 154 listed ETFs in the US made a negative return in the year to March 2005. The worst was the B2B Internet Fund (BHH), down 15%. But the highest return, from the iShares MSCI Brazil Index (EWZ), clocked up an impressive 84% return. So where and what should you go for now?
Head across the pond
Maybe not Britain, where there are only 14 funds and so little variety. But should you head across the pond to the US, you’ll find the ‘dynamic’ market of more than 9,000 stocks has created ‘the perfect playing field for ETF investors’. You can play the four most popular measures for daily market performance, including the Nasdaq Index 100 Tracker (QQQQ), which tends to represent hi-tech or high-growth firms listed on New York’s second market, and the iShare Russell 2000 Fund (IWM), which offers ‘a nice alternative’ to invest in firms not among the 1,000 largest.
Of course, another attraction of ETFs is that you’re not limited to US equity markets alone. The iShares MSCI-EAFE Index (EFA) gives you a portfolio that includes stocks from all major developed nations outside the US.
Investing in the iShares Lehman Bros Aggregate Bond Index (AGG) gives you ‘the entire investment-grade bond market in one portfolio -Â government, mortgage-backed and corporates, the whole shebang’.
Then if you wanted to limit your exposure to stocks in, say, a particularly geographic area, such as Europe or Asia, there’s the Vanguard European Stock Index Viper (VEURX), or the Vanguard Pacific Stock Index Viper (VPAC). You can also invest in ETFs tax-efficiently through a stocks and shares Isa, a small, self-administered pension scheme (SSAS), or a self-invested personal pension plan (Sipp).
Category: Investing in Gold