JEDDAH: An increasing number of investors in the GCC are using ETFs as they look for low-cost ways to build and manage portfolios as well as gain exposure to a range of markets. Robert Broadwell explains the aspects of trading the vehicle as well as how to interpret the costs involved. Exchange Traded Funds (ETFs) have been one of the great investment success stories of the past ten years. They combine the best features of index mutual funds with the trading flexibility of individual securities. ETFs have grown at an exponential rate as they offer diversification, low expense ratios and tax efficiency in a flexible investment that can be adapted to suit a multitude of objectives. The GCC has witnessed a growing interest in ETFs by professional investors who are attracted to ETFs for their simplicity, liquidity and low cost. Before an investor can truly use ETFs strategically to maximize his/her return on investment, however, the investor should appreciate two key elements in using ETFs: Total cost of ownership and the mechanics of trading the products. Let us start by looking at how an investor can trade ETFs. ETFs can be traded on exchange or over the counter (OTC) through a broker, via a direct market access (DMA) broker platform, or with an authorized participant (AP). DMA trading permits buy-side traders to access liquidity pools and multiple execution venues directly, without intervention from a broker's trading desk. An AP is essentially a broker with the ability to create and redeem ETF units, due to their direct relationship with an ETF provider. ETFs are inherently flexible. ETFs trade intraday, so they can be bought and sold rapidly in response to market movements like regular stocks. However, unlike many mutual funds, hedge funds or private equity funds, ETFs impose no minimum holding periods or sales charges when investors chose to exit their ETF holding. Before investing in ETFs, it is important that investors and their advisers understand the costs associated. The cost of an ETF has proven to be one of the key drivers for investor take- up of the investment vehicle. A recent Morningstar survey of 1,000 investors found cost to be the main consideration for investors when choosing ETFs with over 60 percent of current ETF users citing low cost as a 'very important' factor. Traditionally, cost is measured through the total expense ratio (TER), which is the fee charged on an annual basis by the ETF provider for running the fund. This ratio represents the portion of the investment that will be extracted by the fund manger on an annual basis, and is reflected into the daily net asset value (NAV) of the funds. TER is only one element of the total cost, however, and investors should also understand other factors when establishing the true cost of owning an ETF. A more effective means of measuring this cost is by understanding the total cost of ownership (TCO). The TCO concept aims to ensure that investors make their decision to purchase an ETF based on all of the costs and revenues that incur over the holding period. The various elements to total costs of ownership can be summarized into two distinct groups: Explicit and Implicit costs. Explicit costs refer to TER and Commissions & Custody. As ETFs trade just like listed stocks, investors will be charged the same commission fess to trade, settle and custody ETFs as listed stocks. Implicit Costs refers to bid-ask spreads and the tracking difference to the index. ETFs bid-ask spreads on exchange will typically reflect the bid-ask spread of the underlying securities in the underlying index. Other factors that influence bid-ask spreads are the number of on-exchange market makers in a particular ETF and the secondary market volumes. There are now multiple ETF brands tracking the same indices, so investors should consider the bid-ask spreads on-exchange or OTC when comparing various ETFs on the same index. ETFs typically also have some element of tracking difference, defined as the difference in the performance of the ETF vs. the underlying index. The skill of the ETF manager is key in minimizing tracking difference, and investors should incorporate tracking difference in evaluating the total cost of ownership. Let's consider an example that brings these various elements together: say a family office in the GCC has decided to increase their portfolio's exposure to Brazilian equities. The Chief Investment Officer for the family office has decided to use ETFs to implement this change, and is considering two different ETFs that track Brazilian equity indices. At first look, the CIO finds that ETF A has a much lower TER (explicit costs), but when digging a bit further, he realizes that the bid-ask spreads and tracking difference (implicit costs) for ETF A are much more significant that ETF B. While ETF B has a higher TER (explicit cost), the total cost of ownership analysis shows that ETF B is the better choice when all the total costs are considered. It is clear that the various costs and revenues can vary considerably across different ETFs, often by an amount that exceeds any headline differences in the TERs. Investors need to take a broad view by focusing on the total cost of ownership; factoring in costs extending beyond the headline TER and incorporating the impact bid-ask spreads, tracking difference and securities contributing to their decision-making process. – The writer is vice president, iShares __
