Exchange Traded Funds (ETFs) Advisers’ guide to ETFs and their potential role i

Exchange Traded Funds (ETFs) Advisers’ guide to ETFs and their potential role in client portfolios This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. 2 Potential benefits of ETFs 4 ETFs: just another type of pooled investment fund 8 ETFs in context 12 Using ETFs in client portfolios 18 Costs, charges and distributions 22 Understanding how ETFs operate 28 ETF trading: prices, spreads and liquidity 32 Glossary Contents ETFs have some unique characteristics that may make them useful for some investors, including low costs (depending on broker’s fees), liquidity and transparency. In a similar way to traditional index mutual funds, an index ETF also offers diversification in the form of holding the broad market, rather than concentrating risk in fewer holdings. Potential benefits of ETFs Potential benefits of ETFs 3 Costs The annual charges for index ETFs are on average less than many conventional index funds and significantly less than actively managed funds. However, you’ll need to consider the full ‘all in’ cost of investing in ETFs to determine if they are right for a given client or portfolio. This is because ETFs also include costs associated with trading in the stockmarket, such as broker commissions (or flat fees) and bid-offer spreads. Diversification Index funds invest in all, or a representative sample, of securities in an index, providing a highly diversified investment. This offers investors scale, and access to a wide range of investments which may not be accessible otherwise to an individual investor. Liquidity The ability to create and redeem ETF securities on a regular basis ensures an underlying depth of liquidity.* Unlike mutual funds, ETFs can be traded at market prices throughout the trading day, at a price quoted on the stock exchange. Transparency With straightforward ‘physical’ index ETFs, the issuer provides daily information to the market including the ETF basket, or a close representation of the ETF portfolio, and the Net Asset Value (NAV) of the ETF – making ETFs a highly transparent investment option. The difference between physical ETFs and more specialist ‘synthetic’ ETFs is covered further on in this guide. *See later section titled “Understanding how ETFs operate” for an explanation of how this works in practice. Exchange Traded Funds (ETFs) are really just another type of investment fund, usually based on a well-known index, which can be readily traded on a stock exchange. This guide will help you understand how ETFs work along with the potential ways that you can use them in your clients’ portfolios. ETFs: just another type of pooled investment fund ETFs: just another type of pooled investment fund 5 What are ETFs? ETFs available in the EU are pooled investment funds, often regulated under the European Union’s UCITS regime, which can be bought and sold through stockbrokers or stockbroker platforms. Their prices vary throughout the day, which means they can be purchased at a known price anytime markets are open, instead of once a day like most OEICS or Unit Trusts. Like conventional index funds, ETFs offer investors a way to invest in an index portfolio. The indexing approach seeks to track specific market indices, offering the benefits of low operating costs, diversification and simplicity. Index fund Diversified Low cost Low turnover Individual stock Continuously priced Liquid ETF ETFs: just another type of pooled investment fund 6 ETFs are not traded directly with a fund management company. Instead, they are bought or sold any time during stockmarket trading hours directly through a stockbroker. The open-ended nature of ETFs allows for the creation and redemption of shares in the underlying fund to meet investor demand. How do ETFs work? The most popular and straightforward ETFs are based on an indexing approach, which simply seeks to track the return of a target index. For example, a 2% rise or fall in the index should result in approximately a 2% rise or fall for an ETF which tracks that index. Investor (with help of financial adviser) Stockbroker Stockmarket Invest Divest Buy ETF Sell ETF ETFs: just another type of pooled investment fund 7 ETFs are bought or sold any time during stockmarket trading hours through a stockbroker. The open-ended nature of ETFs allows for the creation and redemption of shares in the underlying fund to meet investor demand. Index funds come in a number of different fund structures, including ETFs, OEICs, Unit Trusts and Investment Trusts. A detailed comparison of the four main structures in the UK can help put ETFs in context. ETFs in context ETFs in context 9 Exchange Traded Funds (ETFs) An open-ended investment fund with shares that are traded on a stockmarket. ETFs are priced and traded throughout the business day, and traded through a stockbroker. ETFs can be actively managed or indexed, although the vast majority of ETFs currently available are indexed. OEIC (Open-Ended Investment Company) A pooled investment fund similar to a unit trust, but established under company law, rather than trust law. As such, it issues shares, rather than units, but these are not traded on a stock exchange, they are issued by the OEIC itself. Like ETFs, OEICs increase or decrease the numbers of shares issued in response to demand from buyers and sellers. Unit trust A pooled fund established as a trust. A unit trust is an open ended investment. This means that the manager can create or cancel units depending on public demand. Investment trust A closed-ended fund (a fund with a limited number of shares) established as a company, with the aim of producing returns by investing in other companies. Investment trusts trade like shares on stock exchanges and are priced and traded throughout the business day. They can be bought and sold through a stockbroker. Fund type Trading frequency Open ended Closed ended Daily Throughout the day Unit Trust   OEIC   Investment Trust   ETF   Pooled funds: key characteristics at a glance ETFs in context 10 ETF OEIC Unit Trust Investment Trust Structure Open ended Open ended Open ended Closed ended Pricing Dual priced with bid- offer spreads, with price linked to NAV. Price also affected by market demand (but arbitrage helps keep the price close to the NAV) Single pricing, linked directly to NAV Dual priced with bid-offer spreads, price directly linked to NAV Price indirectly linked to NAV and driven by market demand, can vary dramatically from the NAV Trading Anytime during market hours at real- time prices Once a day on unknown future prices Once a day on unknown future prices Anytime during market hours at real- time prices Access Purchased and sold on stock exchanges through stockbrokers Directly with fund manager, online platform or adviser Directly with fund manager, online platform or adviser Purchased and sold on stock exchanges through stockbrokers Investment style Active or index Active or index Active or index Active (small number of index) PEP/ISA? Yes Yes Yes Yes ETFs in context 11 ETFs are dual priced with bid-offer spreads, with the price linked to the NAV. The price is also affected by market demand, but arbitrage helps keep the price close to the NAV. You can use ETFs in a number of different ways, depending on your client’s investment objectives and risk profile. ETFs can help you to build tailored, diversified, low-cost portfolios exclusively, or to compliment an existing portfolio. Using ETFs in client portfolios Using ETFs in client portfolios 13 Determining your client’s suitability to ETFs You can think of index ETFs as just another way to access investment exposure to a market index. But there are a few things that you’ll need to consider when determining the suitability of ETFs for a given client, including: • Whether the client wishes to invest a lump sum, or add to their investment regularly • The size of the client’s portfolio and the transaction amounts • The client’s investing time horizon • The relevance of trading strategies for the client’s portfolio, such as stop-loss orders • The client’s appetite for risk Lump sum versus regular investing Clients need to know that stockbroker fees and bid-offer spreads apply when buying (and selling) an ETF , even if the ETF has cheaper annual expense ratios when compared to a similar OEIC or Unit Trust. These up-front costs can mean that an ETF might be more cost effective for clients making large, infrequent contributions to their portfolio. However, investors making ongoing, smaller contributions may be better suited to a traditional mutual fund where costs are based on a small percentage of each contribution instead of a fixed amount per trade. You will need to analyse the full investing round-trip costs involved carefully before making a recommendation. Using ETFs in client portfolios 14 Time horizon ETFs often have cheaper annual expense ratios when compared to an equivalent mutual fund, which can make them attractive as a long-term investment. However, when uploads/Litterature/ etfs-adviser-guide.pdf

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