Investors frequently follow the rise and fall of stock indices and various commodities such as energy, agriculture and metal, wondering how they may participate in their performance. Investing directly in these products or indices may prove costly and cumbersome – say, one could take delivery of five tonnes of wheat, store it and sell it on at a later stage.

Naturally this would be impractical unless of course you produce products requiring wheat as a raw material. Or one might invest in every constituent of the FTSE 100 in their respective index weighting to mimic the index, however this could prove very costly.

An alternative is to invest in an index tracker, a traditional fund set up to track the return of an index, or perhaps a fund which tracks the price of an underlying commodity. These funds issue or redeem shares priced at the end of each trade date, and the fund’s net asset value is determined by the closing prices of the stocks held in the portfolio.

However, an easier and less expensive way is to buy an Exchange Traded Fund. ETFs track their origins to 1989 with an S&P 500 proxy that traded on the American and Philadelphia Stock Exchanges; however it was not until 1993 that ETFs saw a huge increase in their use with the development of SPDRS (or “Spiders”). In 2000 Barclays Global Investors launched the iShares line and within five years this range outstripped the total assets of all its global competitors.

An ETF is an open-end fund similar in most ways to traditional funds – the main difference being that ETFs trade throughout the day on an exchange much like the shares of individual companies. The securities making up an ETF can be varied, and are generally designed to closely track a broad index or it may track specific countries, sectors, commodities, currencies, bonds or other asset classes. Other acronyms such as ETP and ETC refer to Exchange Traded Products and Commodities respectively.

The use of ETFs has increased dramatically since inception. BlackRock quoted in the 2010 year end edition of its publication “ETF Landscape” that as at end December 2010 there were 3,503 exchange traded funds and products holding $1,482 billion assets under management through 7,311 listings on 50 exchanges worldwide – an increase of $323.2billion, or 28 per cent, over 2009, almost doubling the 2008 figure and 3.5 times the 2005 number.

Each ETF has exchange specialists (or authorised participants) acting as market-makers for the fund’s shares, dealing with ETF managers directly by delivering the underlying assets held by the ETF in exchange for fund shares. The redemption process takes a similar pattern, whereby authorised participants accept the underlying assets in exchange for ETF shares.

This in-kind process prevents the net asset value of ETFs from trading at significant premiums or discounts to the value of its underlying assets, otherwise a risk-free profit opportunity arises: should the ETF trade at a discount to the underlying assets, exchange specialists buy the ETF and sell the underlying assets. The possibility of this occurrence ensures the ETF price remains loyal to the underlying value.

Furthermore, this process provides a tax advantage for ETFs versus traditional funds – ETFs are not taxed on realised capital gains. When investors sell shares to market-makers, the latter exchange the ETF shares for the underlying assets with no cash changing hands. In a traditional fund, cash redemptions could mean that the fund might have to sell holdings in its portfolio. If these securities appreciated in value, the fund realises a capital gain, and the tax burden passed on to all existing fund shareholders. This tax advantage could be significant when compounded over time.

ETFs are more transparent than traditional funds as managers announce their holdings in their portfolios at the beginning of each trading day, meaning that investors know the exact composition of the ETF at any time. Traditional funds generally disclose their holdings on a quarterly or semi-annual basis.

ETFs have some of the lowest expense ratios among all funds, typically less than one per cent p.a – the average traditional fund charges one to three per cent. Investors also have the opportunity to short the market by purchasing an ETF whose price performs exactly opposite to the underlying index. So if the FTSE 100 loses one per cent in one day, the short ETF increases by one per cent. There are also leveraged ETFs, funds that track two or three times an index’s daily returns.

When purchasing precious metals ETFs, we believe that one of the most important features is that the fund is physically-backed. This means that every ETF share has a claim on bullion held in an account with a custodian in the client’s name.

Given the above characteristics, it is no surprise that the use of these investment vehicles has gained so much popularity. With the current economic backdrop behind the capital markets, the use of ETFs, particularly commodity related ones, might make sense. A future article will tackle the use of ETFs within investment portfolios.

This article was prepared by Vincent Micallef, an investment executive at Curmi and Partners Ltd, and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business. Should you wish to discuss this article in further detail, feel free to contact the author on 2342 6116.

www.curmiandpartners.com

Mr Micallef is an investment executive with Curmi & Partners Ltd.

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