Our guide: ETFs made simple

David Bower, head of marketing for iShares EMEA, unravels some of the misconceptions about exchange-traded instruments.

Exchange Traded Funds (ETFs) are amongst the fastest growing investment products in the UK. Recently, the level of interest in ETFs from UK financial advisers has grown.

ETF growth is driven by the increasing adoption of index and passive strategies to construct well diversified portfolios, coupled with the highly effective structure, delivering low cost, transparent and liquid access to a wide range of financial markets. The structure provides the familiar benefits of mutual funds.

Critical to UK investors is UK reporting status and eligibility for the mainstream tax wrappers such as ISAs, SIPPs and onshore and offshore bonds. 

Against this backdrop of rapid growth, coupled with the fact that private investors can access ETFs directly on the secondary market, we are not surprised that regulators are paying close attention to developments.

Authorities such as the Bank of England and the European Securities and Markets Authority have confirmed they will be researching the ETF sector, and the suitability of existing regulations, to ensure the industry continues to develop on a safe and sustainable path. Their focus is to identify whether there are any practices associated with the construction and distribution of ETFs that are not well regulated through existing frameworks.

In addition, there are concerns investors could confuse other instruments that trade on exchange, such as Exchange Traded Notes (ETNs), as offering the same protections as ETFs. ETNs are essentially unregulated products, governed by a framework of disclosure, and promoters of these products have much more flexibility in the construction process both in the exposure offered, and their structuring.

While regulators undertake their review of the industry, it is vital advisers and investors carry out their own due diligence when selecting an ETF, much as they would with any active fund.

On the surface, many ETFs that offer the same exposure appear the same, but there are material differences between providers and their approaches to index replication, liquidity provision, performance track record and commitment to transparency.

Physically replicating ETFs

Physically replicating ETFs are among the easiest structures to understand. The majority of global ETF assets track their index using physical replication. Here, the manager purchases all, or a sample of the securities that make up the index. For example, a physically-backed S&P 500 ETF will be holding all, or a sampled proportion, of the shares of US companies that form the constituents of the S&P 500 index.

Investors receive the return from these securities, adjusted for costs and additional revenues available, delivering the return of the index. There is a high level of transparency for investors, a key advantage of this structure.

As long holders of the securities that make up the index, the fund shareholders are able to take advantage of revenues from the securities lending market. As a core practice of portfolio management, particularly in the index industry (where stable holdings in blue chip securities enable the generation of strong returns), the ETF promoter should make details of its programme and the revenues generated readily available to investors.

Synthetics in focus

Much interest from regulators has focused on the growth of assets held in ETFs that utilise synthetic replication, also known as swap-based ETFs. According to BlackRock research, swap-based ETFs accounted for approximately 45% of assets held in ETFs in Europe at the end of Q1 2011.

These ETFs rely on a swap agreement between an investment bank (the swap counterparty) and the fund provider to deliver an investment return. There are two models, with the unfunded model being the primary focus of regulators.