INDEX FUNDS AND EXCHANGE TRADED PRODUCTS COMPARED. Viewpoint IN THIS ISSUE. Examining different passive options for client portfolios

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1 This document is for investment professionals only and should not be relied upon by private investors INDEX FUNDS AND EXCHANGE TRADED PRODUCTS COMPARED Examining different passive options for client portfolios Viewpoint IN THIS ISSUE 2 INCREASING CHOICE IS FUELLING THE GROWTH OF PASSIVE INVESTING 4 INDEX TRACKING A SIMPLE CONCEPT 5 INDEX FUNDS 6 EXCHANGE TRADED PRODUCTS 8 COMPARING CHARGES 9 INDEX FUNDS AND ETPs: AT-A-GLANCE SUMMARY 10 MAKING YOUR CHOICE 11 INDEX OPTIONS AVAILABLE ON FUNDSNETWORK

2 This document is for investment professionals only and should not be relied upon by private investors Passive funds can differ in many ways and so taking a closer look can be crucial IN THIS ISSUE 2 THE GROWING MARKET FOR INDEX FUNDS 3 WHAT TO LOOK FOR IN AN INDEX MANAGER 11 INDEX FUNDS ARE NOT ALL THE SAME This document is for investment professionals only and should not be relied upon by private investors Using a core-satellite approach to blend active and passive funds together IN THIS ISSUE 2 BLENDING PASSIVE AND ACTIVE STRATEGIES TOGETHER CAN BRING MANY BENEFITS 3 DIVIDE AND CONQUER 4 INCORPORATING INDEX FUNDS INTO CLIENT PORTFOLIOS INCREASING CHOICE IS FUELLING THE GROWTH OF PASSIVE INVESTING Index tracking as an investment methodology first emerged in the 1970s. Since that time, it has been growing in popularity and it is now considered to be a mainstream strategy. Indeed, according to the Investment Association, billion was invested in tracker funds as at the end of July 2015, accounting for almost 12% of industry equity funds 1 under management. This trend is not just a UK occurrence the global market share of low-cost passive investments is predicted to reach 22% by There are many reasons driving the growth in passive investing. Investors are being attracted by the low inherent costs of the approach as well as the consistent delivery of a return close to the market. A greater focus on asset allocation rather than fund selection is also having an influence while the industry s move to fee-based advice has made it easier for advisers to recommend index products. Indeed, we are increasingly seeing firms use index funds as core holdings within model portfolios. Another factor in the rise of index tracking is undoubtedly increased choice. More and more options are becoming available all the time and this includes alternatives to traditional index funds such as Exchange Traded Products (ETPs). ETPs themselves have experienced huge growth over the last few years and there are now more than 2,100 ETPs available across Europe. Figures from ETFGI, an independent research and consultancy firm, show that record levels of net new assets have been gathered by ETFs/ETPs in Europe, in the first eight months of 2015, net inflows climbed to US$59.7 billion representing a 17% increase on the record set at the end of August The market for ETPs in Europe has been led by institutional investors it is estimated that 20% or less of buyers are retail investors. However, the US is normally a good gauge of how the market will develop and in the States retail investors account for an estimated 50% of ETP sales. 4 We therefore expect ETPs, as well as index funds more generally, to become more prominent in client portfolios in the coming years. This Viewpoint looks at passive investment options more closely, comparing and contrasting ETPs to traditional index funds, which are generally more widely understood. SELECTING THE RIGHT INDEX MANAGER Viewpoint INCORPORATING INDEX FUNDS INTO CLIENT PORTFOLIOS Viewpoint Read our complementary Viewpoints on passive investing Further insights on index tracking investments can be found within two other Viewpoints available on our website. Selecting the right index manager explores some factors to consider when selecting an index fund while Incorporating index funds into client portfolios looks at how index products can form part of an individual s investment strategy. You can access these at fundsnetwork.co.uk/index What are Exchange Traded Products? Exchange Traded Products (ETPs) is a collective term used to describe both Exchange Traded Funds (ETFs) and Exchange Traded Commodities (ETCs). An ETF is an open-ended pooled investment fund, similar to a unit trust or mutual fund, which can be bought and sold on a stock exchange like a share in a company or traded through a platform. ETFs are typically index tracking funds that are managed to mirror the performance of an index, such as the FTSE 100. An Exchange Traded Commodity (ETC) is an investment vehicle that tracks the performance of an underlying commodity index (such as precious metals, oil, coffee and cotton). 1 IA, August PwC, ETFGI, August FT Adviser/Deutsche Asset & Wealth Management, April

3 INDEX TRACKING A SIMPLE CONCEPT INDEX FUNDS Both traditional index funds and ETPs seek to deliver the performance of a given index as closely as possible. They typically aim to do this by holding all the stocks within an index where the proportions correspond to the stock weightings in the index or by holding a representative sample of the index s constituent stocks. When a change such as a stock entering or leaving the index occurs, an index fund or ETP will typically follow this move. Another less common way to track the performance of an index is through synthetic replication, which involves the use of derivatives. The performance of any given index tracking product is unlikely to match the performance of the index precisely due to a number of factors. Charges are one of the main reasons for this both the fund s ongoing charges and the costs relating to trading will have an impact. Less obvious factors include taxation and cash flow management. An important point to remember is that, while index investments tracking the same benchmark may appear to be very similar, they can actually differ quite widely. Key things to consider when selecting a passive investment for a client s portfolio include: The product s pricing/charges The tracking approach/ methodology employed by the fund or ETP The tracking difference and tracking error of the fund/etp The scale and size of the manager A fund s stock lending policy The coverage of the benchmark being tracked, tax treatment and whether gross or net share classes are offered or not. For more on these factors, please download our Viewpoint on selecting the right index manager. WHILE INDEX INVESTMENTS TRACKING THE SAME BENCHMARK MAY APPEAR TO BE VERY SIMILAR, THEY CAN ACTUALLY DIFFER QUITE WIDELY. Index funds are, of course, relatively straightforward investments and professional investors will generally be very familiar with the concept. Leaving aside their investment methodology, they tend to offer the characteristics defined below: Open-ended the number of shares or units in the fund can be increased through issuing new shares/units or reduced by eliminating existing shares/units according to demand. Traded daily an investor will buy or sell shares/units in a fund at the price set at the next valuation point. Pricing OEICs tend to be single priced while unit trusts are dual priced with a bid-offer spread. Prices are directly linked to the fund s NAV. Charges these are typically low, especially compared to active funds. A fund s ongoing charges will be defined within its Key Investor Information Document. Platform charges may also apply as could dilution levies or a swinging price policy in certain circumstances. Some managers may also impose buy and sell charges. Dividends these are either accumulated within the fund or can be distributed/reinvested where income share classes are available. Investment flexibility minimum investment is typically from 1,000 with tops ups from 250. Index funds can be ideal for regular purchases with payments starting from around 50. Tax wrappers index funds are typically available in a wide range of wrappers, including ISAs and SIPPs. Tax treatment this will depend on a fund s domicile but those available in the UK are generally regarded as onshore investments for tax purposes. Investor protection where a fund is domiciled in the UK, it will be covered by the UK Financial Services Compensation Scheme (FSCS). Of course, the above is just a generalisation and you should check the particulars of each individual fund before you make any recommendation. 4 5

4 EXCHANGE TRADED PRODUCTS ETPs are very similar to traditional index funds in that they aim to deliver a return as close to the relevant index as possible. The main difference between the two product types is that ETPs can usually be traded continuously through market hours, while index funds can only be traded once a day at the forward valuation point. These products track their benchmarks in two main ways. In much the same way as index funds, ETPs can track an index through physical replication, usually through full replication or by optimisation/sampling. Alternatively, synthetic or swapbased replication may be used. This approach has developed over recent years and relies on using a swap agreement between an investment bank and the fund provider. In effect, the ETP holds a basket of securities prescribed by the swap counterparty and agrees to exchange the performance of this basket for the performance of the relevant index. It can be a precise way of tracking the benchmark (before fees) and can be particularly useful when it is difficult to physically track the benchmark. However, this method does involve counterparty risk. ETPs are presently much more of a tool for institutional investors rather than retail investors (although this is gradually changing). Professional investors tend to use ETPs to gain short-term exposure to the market. For instance, a mutual fund may hold a small proportion of its assets in Exchange Traded Funds so that it can manage cash flows more easily. This can mean that ETPs are prone to large inflows and outflows on a regular basis. Smart beta ETFs a new phenomenon The last few years has seen the emergence of so called smart beta ETFs. These products try to enhance the return from tracking an index by deviating from the traditional cap-weighted approach whereby stock weights correspond to those of the index. Instead of using a cap-weighted approach, stocks are typically weighted based upon a different factor (or a combination of factors) such as sales, dividends, volatility, cash flows, etc. While you will need to check the individual characteristics of each ETP you recommend, they typically have the characteristics listed below: Open-ended ETPs are open-ended investments whereby shares can be created or cancelled depending on demand. Intra-day trading ETPs can be traded at any time during market hours at real time prices. However, this may not be the case if traded through a platform (FundsNetwork, for instance, will only place deals on behalf of investors once a day). Pricing they are dual priced with a bid-offer spread. Prices are directly linked to the NAV (although they can be affected by market demand meaning the ETP can trade at a premium or a discount). Charges in addition to the bid-offer spread, other charges will apply: 1. There will usually be a dealing fee on the FundsNetwork platform, for instance, all ETP trades are placed through JP Morgan and incur a charge of 0.1% per individual deal (a switch is considered as two separate deals). 2. As with fund investments, ETPs will have ongoing charges. For those available through FundsNetwork, these are shown in the relevant KIID or Fund Specific Information document.* 3. A platform fee may apply. 4. Some providers may impose dilution levies in certain circumstances. Dividends these are either accumulated within the ETP or are distributed to investors depending on the product. If distributed dividends are to be reinvested, a trade will need to be placed which incurs a further cost. Liquidity this is a factor to consider when investing through smaller ETPs. Shares can be harder to sell when market liquidity dries up and so bid-offer spreads can vary. It is a good idea to check an ETP s daily trading volume and how many market makers/dealers the product trades through before placing a deal. Investment flexibility trades of any size can generally be made at any time, although a dealing fee will apply in addition to the bid-offer spread. Minimum deal sizes will generally apply to deals placed through platforms. Tax wrappers ETPs can be included in a number of wrappers, although availability will depend on the provider. On the FundsNetwork platform, they can be included within ISAs, unwrapped investment accounts and the FundsNetwork Pension (from Dec 2015) but not within a Bond wrapper. Tax treatment due to their domicile, most ETPs are classified as offshore investments and are regarded as such for tax purposes. They will therefore require reporting status under the UK tax rules for offshore funds. Investor protection as most ETPs are offshore investments, they are not covered by the UK Financial Services Compensation Scheme (although other protections may be available in the locations where they are domiciled). *Please note that the ETFs distributed through FundsNetwork are classified as UCITS and therefore fall under the requirement to have a Key Investor Information Document (KIID). The ETCs distributed through FundsNetwork are debt securities, not UCITS, and therefore have Fund Specific Information documents rather than KIIDs. 6 7

5 COMPARING CHARGES INDEX FUNDS AND ETPs AT-A-GLANCE SUMMARY ONGOING CHARGES COMPARED INDEX FUNDS EXCHANGE TRADED PRODUCTS % % Cheapest Equity Index Fund Cheapest ETP 0.07% 0.07% 0.07% FundsNetwork, October Please note that ongoing charges can vary over time and the latest charges can be found within the relevant KIID or Fund Specific Information document (available on our website). The analysis only considers ongoing charges as quoted in a fund s/etp s Key Investor Information Document and other charges will apply. Lowest ongoing charges quoted are for Fidelity Index UK Fund P Acc, ishares Core FTSE 100 UCITS ETF, Fidelity Index US Fund P Acc, ishares Core S&P 500 UCITS ETF, Fidelity Index Europe ex UK Fund P Inc, ishares MSCI Europe ex UK UCITS ETF, Fidelity Index Japan Fund P Acc, ishares Core MSCI Japan IMI UCITS ETF, Fidelity Index Pacific ex Japan Fund P Inc, ishares Core MSCI Pacific ex Japan UCITS ETF, Fidelity Index Emerging Markets Fund P Acc, ishares Core MSCI Emerging Markets IMI UCITS ETF, Fidelity Index World P Inc, ishares MSCI World UCITS ETF. Given index funds and ETPs tracking the same market are essentially attempting to deliver the same end result (a return close to that of the market), costs will usually be one of the key factors in deciding which is the best option for any given client. The analysis above shows the cheapest options for both product types currently on the FundsNetwork platform for the major equity market sectors. However, it should be noted that the examples shown are not 0.10% 0.10% 0.10% UK US Europe ex UK Japan Pacific ex Japan Emerging Markets World 0.25% 0.13% necessarily tracking the same market index (for example, the cheapest UK index fund tracks the FTSE All Share Index while the cheapest UK ETF tracks the FTSE 100 Index). It should also be remembered that other costs will apply. A bid-offer spread will apply to dual priced funds and ETPs and ETP deals will also attract a dealing charge. There will also be a platform charge and investor fee for both product types when held on the FundsNetwork platform. Additionally, some managers may impose buy and sell charges. 0.20% 0.21% 0.20% 0.13% 0.25% Structure Open-ended Open-ended Trading Daily at next valuation point At any time during market hours Pricing OEICs are usually single priced while unit trusts will be dual priced Bid-offer spread Only when dual priced Yes Dealing charge No Yes Dual priced Ongoing charges Yes, as detailed in the Fund s KIID Yes, as detailed within an ETF s KIID and an ETC s Fund Specific Information document Access Typical wrapper availability Through a platform or directly with the fund provider ISA, SIPP, International Bond and unwrapped investment accounts Through an exchange or a platform ISA and unwrapped investment accounts Dividend treatment Distributing or accumulating Distributing or accumulating Reinvestment of dividends (where applicable) Where income shares/units are held, dividends can be automatically reinvested Tax status Usually onshore Usually offshore Covered by the UK Financial Services Compensation Scheme Yes, if domiciled in the UK If distributed dividends are to be reinvested, a trade needs to be placed which incurs a cost No, if offshore products, although other protections may apply Please note that, in addition to ongoing and dealing charges, other fees may apply. Some managers may impose buy and sell charges, while platform charges may also apply. Dilution levies and swinging price adjustments may also be imposed in certain circumstances. 8 9

6 MAKING YOUR CHOICE INDEX OPTIONS AVAILABLE ON FUNDSNETWORK Deciding whether an index fund or ETP is the right choice will obviously very much depend on individual client needs. However, as we have already stated, costs will usually be a key factor if the two options are tracking the same index. Wrapper availability could also be an important consideration as may the domicile/tax status of the product. One of the main attractions of ETPs is the ability to trade throughout market hours. In this way they have similar characteristics to stocks and investment trust units in that they can trade at a premium or discount to the NAV. ETPs may therefore have more appeal for active investors where the ability to trade at any time is important (please note this facility is not available for ETPs on the FundsNetwork platform). They may also be more appropriate for where short-term exposure to a market is required. For regular investors, index funds may be more appropriate as a bid/offer spread and dealing charges will apply to all individual ETP trades. For investors considering holding the two low cost solutions together, index funds represent an ideal option for core long-term holdings whereas ETPs could be used for active daily or regular trading purposes. DECIDING WHETHER AN INDEX FUND OR ETP IS THE RIGHT CHOICE WILL VERY MUCH DEPEND ON INDIVIDUAL CLIENT NEEDS. FundsNetwork offers a broad range of index tracking investments to meet a wide range of client needs. In total, there are currently over 230 passive options available (as at October 2015), a number which is growing all the time. This includes over 60 ETPs from three different providers. There are 46 Morningstar categories represented across the passive fund range. The FundsNetwork Fund Evaluator tool can help you search out the right solution for your clients' needs. Simply visit the tool and then tick the 'Passive Funds' box in the left hand column to filter the list. If you wish to filter by region or investment sector, you will need to log into Client Management first. Visit our index support zone fundsnetwork.co.uk/index for more on investing in index funds including other Viewpoints giving further perspectives on passive investing. THE FUNDSNETWORK FUND EVALUATOR TOOL CAN HELP YOU SEARCH OUT THE RIGHT SOLUTION FOR YOUR CLIENTS' NEEDS. Introducing the Fidelity Index Tracker Range The Fidelity equity index fund Range offers your clients access to a broad range of markets from just 0.06% (ongoing charges), exclusively through FundsNetwork. Seven different fund options: World UK Europe ex UK US Japan Pacific ex Japan Emerging Markets Great value fixed ongoing charges for example, just 0.06% and 0.07% for the UK and US index funds respectively Accumulation and income shares are available across the range Fully integrated into the platform they are available within FundsNetwork s ISA, Pension and International Bond as well as non-tax wrapped accounts and can be included within your model portfolios. Importantly, Fidelity has priced the range to be highly transparent. The fixed ongoing charging structure means costs are consistently low. A FundsNetwork platform service fee of 0.25% does apply as will an annual investor fee of 45. For more information, simply visit fundsnetwork.co.uk/index or call today

7 For more on our extensive range of index funds and ETP passive options, visit: fundsnetwork.co.uk/index or call This document is for investment professionals only and should not be relied upon by private investors. The value of investments can go down as well as up and clients may get back less than they invest. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, FundsNetwork, their logos and F symbol are trademarks of FIL Limited. UKM1015/6745/SSO/1016.