Build a portfolio that will survive the test of time with Exchange Traded Funds

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1 READ OUR FULL RISK WARNING. The value of investments and any income from them can fall as well as rise, and you may get back less than you invested. An investment s past performance is not a reliable indicator of future performance. Tax allowances depend on your personal circumstances and the benefits of tax-efficient accounts could change in the future. Build a portfolio that will survive the test of time with Exchange Traded Funds Introduction The world s first Exchange Traded Fund (ETF) was launched in 1993 by Statestreet Global Advisors. Since then ETFs have continued to grow in popularity and gather assets at a rapid pace. The easiest way to understand the way ETFs work is to think of them as a mutual fund that trades like a stock. ETFs have many unique advantages over mutual funds and it is these advantages that we will drill into throughout this report. ETFs have very similar characteristics to mutual funds as we have previously mentioned. Just like an index fund, an ETF represents a basket of stocks that reflect an index such as the S&P 500. An ETF, however, isn t a mutual fund, it trades just like any other company on a stock exchange. Mutual funds are priced once per day, at the close of business, so everyone purchasing the fund that day gets the same price, regardless of the time of day their purchase was made. Like traditional stocks and bonds, the ETF market can be traded on an intraday basis, therefore opening up a whole universe of opportunity to speculative investors to bet on the direction of short term movements. The knock on effect of this is that it creates a vast pool of liquidity in these instruments, making investing very simple. The Benefits of ETFs Diversification There are now thousands of ETFs available to invest in and they cover a whole range of areas. Every major index (S&P 500, Dow Jones, Nasdaq, FTSE 100, etc.); and sector of equity markets (large caps, small caps, growth and value); International ETFs regional ETFs and country specific ETFs. Even specific industries and niche markets are at the disposal of investors. Fixed income and commodities are also available although, the offering in the fixed income area does offer fewer choices, but there are still plenty for investors to get lost in. Studies have shown that asset allocation is the primary factor responsible for investment returns, and ETFs offer a very convenient way for investors to build portfolios that meet the needs of specific asset allocation. Should a cautious investor wish to build a portfolio consisting of 80% bonds and equity, this can easily be created through the use of ETFs in a very simple and straight forward way. Too much emphasis has been placed in the past on achieving absolute return, and as a result the understanding of the risks being taken can be neglected. The aim of your investment should be to achieve the highest return while taking the minimum amount of risk. Through diversification you can spread your investments far and wide over a range of asset types, countries and sectors. If you have exposure to a broad range of assets, then over time the poor performance experienced in one type of asset will be compensated for by stronger performance in another and vice versa.

2 Costs ETFs are a great tool for investors who like to make a saving. Investment products can sometimes charge high management fees as well as adding in other hidden costs. These costs can amount to large barriers to overcome and easily cancel out any gains made by your investment. ETFs have one primary cost element known as the Total Expense Ratio (TER). The TER represents the total cost to hold an ETF investment for one year. This figures includes all the annual costs relating to fund management. The average TER is usually higher than that of a traditional passive fund. The main reason for a higher TER is that ETFs can be traded throughout the day, while passive funds trade only once. Transparency With some mutual funds there can be considerable uncertainty as to whether or not your investment is meeting its targets, as there is so little information available on how the fund is performing day-to-day. The increased level of transparency with ETFs significantly discourages dishonesty, as there is very little a fund manager can do to manipulate a fund when its picks are tied to the performance of an index. Because of the liquidity in the market and the millions of trades that pass through these instruments, there is no room to take advantage of the stale pricing that occurs after the markets close and mutual fund orders are settled. As an ETF investor, you are much less likely to be confused than investors are in active mutual funds. Popularity and Liquidity Since the launch of the first ETF back in 1993, the growth in the ETF industry has been exponential. There is now globally around $1.6 trillion invested in ETFs. Europe had been a little slow on the uptake of ETFs, but again the popularity has soared over the past few years with around 308 billion invested in total. ETFs are heavily used by pension funds, Government agencies and private banks who have been investing in ETFs for many years. This popularity is now increasingly spreading to private investors keen to take advantage of the cost effective and flexible investment solutions on offer. The momentum in ETFs can be seen in the first half trading figures of 2013 across the three main asset classes of equities, fixed income and commodities they all experienced significant increases in trading volumes, which were up as much as 28.1% on the year previous. Trading volumes occur as a direct result of supply and demand. In the financial world, lower risk securities are more freely traded in particularly, and therefore have higher trading volume and liquidity. ETFs that invest in actively-traded securities will be more liquid than those that do not. Tax efficiency and access ETFs tend to sit very well with tax savvy investors because the portfolios that ETFs represent are even more tax efficient than index funds. Due to the indexed nature of ETFs it means that investors trading large volumes will receive in-kind redemptions, so investors can redeem them for the shares of stocks that the ETFs track. This arrangement minimizes tax implications for the investor exchanging the ETFs since the investor can defer most taxes until the investment is sold. Capital gains taxes are to be paid on the profitable sale of an ETF, and distribution of dividends is taxed in the normal way.

3 Perhaps the biggest advantage of buying ETFs in the UK is that they are entirely exempt of stamp duty. To purchase a single stock would incur a charge of 0. at source, so to put this into perspective to buy a portfolio of 15 stocks in the UK would cost 15 lots of commission charged by a broker and an additional 0. in stamp duty. Variety of ETFs Due to the soaring popularity and demand for new ETF products, it is now possible to invest in almost anything through exchange traded funds. Index ETFs remain among the most popular and you will find every single provider in the market will offer their own version of the world s major and minor indices. Bond ETFs are extremely popular among risk adverse investors and work well as a safe haven during economic recessions. In 2005 Rydex Investments launched the first ever currency ETF in New York, since then a series of funds tracking all major currencies have been created. Beyond this, ETF Securities launched an ETF FX platform covering 18 long or short US Dollar vs. single G10 currencies. These total return products allow investors access to the extremely popular spot FX markets and also give opportunities for savvy investors to hedge any current currency exposure they may have. Commodities have always been popular investment medium for investors, but access has at times been restricted due to large minimum investment levels through futures contracts. The birth of ETFs now gives the everyday investor the opportunity to invest in almost every commodity you can possibly think of. Probably the most innovative creation to be offered to the ETF world is the development of inverse and leveraged ETFs. Through the use of inverse ETFs investors can now bet on the inverse of whatever index or benchmark it is designed to track. These funds work by using short selling, trading derivatives such as futures contracts, and other leveraged investment techniques. Leveraged ETFs use financial derivatives and debt to amplify the returns of an underlying index. They are now available on most indexes, commodities and fixed income securities. These funds aim to keep a constant amount of leverage during the investment time frame, which in some cases is up to 3x. Common misconceptions of ETFs ETFs are just another fad The first ETF was launched in 1993, when the investment landscape was a very different place. With over $1.6 trillion invested globally, ETFs have stood the test of time having been through a whole number of major market events including the tech bubble, banking crisis and Eurozone crisis. It is safe to say that ETFs are here to stay. ETFs and passive funds aren t exciting It is often difficult to find active funds that consistently outperform over the long term. Both active and index strategies have a role to play in a well-diversified portfolio. The opportunities for building customised portfolios through ETFs is near endless and they come with the added benefit of doing it in a cost efficient way. ETFs are more expensive than other passive funds

4 ETFs may appear to be more expensive due to the fact that the average TER is usually higher than that of traditional passive funds. The main reason for this is the fact that ETFs are exchange-traded, hence allow investors to benefit from intra-day liquidity. This intra-day trading mechanism comes at a cost. ETFs are more risky ETFs trade on a regulated exchange and the objective is to replicate the returns of the defined benchmark. The ETF price follows the underlying benchmark with no capital protection or guarantee. This is usually referred to as market risk. Some currency risk can be involved when the ETF tracks a benchmark index denominated in a foreign currency. It s difficult to know what exactly I am invested in ETFs are exceptionally transparent, it is very easy to see what an ETF holds, its performance and its costs. Disclosures will vary between providers, however most will update this information on a daily basis. This transparency lends itself to greater control and efficiency over investing. What are the risks of investing in ETFs? Taxation and Currency It is important to check where a particular ETF is domiciled, as more often than not they will be outside of the exchange country in which they are listed. This is particularly relevant with UK investors investing in US based ETFs. Firstly they are valued and traded in dollars, which pose a currency risk. But secondly and more importantly any gains made are subject to income tax rather than capitals gains. It would be an easy mistake to make expecting any gains made to be within your allowance, only to find out that you are paying income tax. If you are in the higher band of tax, you could relinquish up to 50% of your profits in tax. ETFs with derivative exposure Clearly there is much higher risk associated with leveraged and inverse ETFs as losses can quickly accumulate if you are not risk aware. Any product containing derivatives will naturally increase the risk profile. Tracking error Exchange traded investments seek to replicate performance of an index, currency or commodity. However such factors as charges, index changes cash drag and optimisation can all impact upon the correlation with the underlying investment. While this is typically very low, it can vary from provider to provider. Counterparty risk Exchange traded investments do not always hold the physical assets. They may use futures and options to provide exposure. If the investment bank providing the option fails, the exchange traded investment will lose part or all of the money it has invested with that institution (Lehman Brothers is the obvious example).

5 Model portfolios We will conclude this report with some examples of how a diversified portfolio could look according to differing levels of risk. Moderate Risk 10% Emerging Market Equities Euro Governement Bond 7-10 year European Corporate Bond Large Cap European Equities European Inflation Linked Bond US Equities US Treasury 10 Year Balance Risk % 1 2 Emerging Market Equities Euro Governement Bond 7-10 year European Corporate Bond Large Cap European Equities European Inflation Linked Bond US Equities US Treasury 10 Year High Risk 10% 10% Emerging Market Equities 10% 30% 30% Euro Governement Bond 7-10 year European Corporate Bond Large Cap European Equities European Inflation Linked Bond US Equities US Treasury 10 Year

6 There are many providers that will offer their own version of ETFs capable of catering for all of the above. There is no right or wrong, we advise do your own research to decide which the best option for you is. Please feel free to contact one of our advisors, should you be interested in any more information or need some assistance. Summary We hope to have highlighted all the great benefits of investing with ETFs and also highlighted some potential pitfalls. This should enable you as an investor to make better and informed investment decisions. ETFs have seen some spectacular growth in popularity and in many cases this popularity is warranted. Making good investment decisions requires knowing all of the facts about the vehicles you decide to use and understanding the dangers will help avoid any nasty surprises to your bottom line. RISK WARNING: This report is issued by Central Markets (London) Limited trading as Central Research (CR) of America House, 2 America Square, London, EC3N 2LU, which is authorised and regulated by the Financial Conduct Authority, No Exchange Traded Funds are passive investments mirroring a market or index. Success is entirely dependent on the market or index you are trading. ETF s are subject to market volatility and the risks inherent in their underlying securities. Each ETF has a unique risk profile which must be carefully considered before making an investment. There is no guarantee that you will not lose your capital and smaller funds can be illiquid. ETFs which use leverage are subject to additional risks. The return from an ETF is usually different from the index it tracks because of fees, expenses and tracking errors. If you are in any doubt, please seek further independent advice. Remember, tax laws may be subject to change. Any person placing reliance on the report to undertake trading does so entirely at their own risk and CR does not accept any liability as a result. Information and research produced by Central Research, does not constitute a recommendation or offer to make a transaction in any derivatives or securities, and is intended to be general in nature. This report is prepared and distributed for information purposes only.