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With donations expected to be
impacted adversely by the
economic downturn recession,
interest on bank deposits suffering from
the fall in base rates and the malaise
afflicting global stock markets making
investments more difficult, one might
expect exchange-traded funds (ETFs)
to be high on the radar of charity
investment managers.
After all, these investment vehicles,
which hold assets such as stocks and
bonds and are traded much like shares,
are increasingly popular with institutional
investors because of their low costs and
tax efficiency.
In a survey of investment professionals
conducted in March 2008 by State Street
Global Advisors and
Knowledge@Wharton, the online
business journal of the Wharton School of
the University of Pennsylvania, 67% of
respondents called ETFs the most
innovative investment vehicle of the last
two decades.
Another 60% said ETFs had
fundamentally changed the way they
construct investment portfolios.
Of course, charities have similar
requirements to long-term, risk-averse
institutional investors in that they need
reliable and predictable investments
producing solid compound growth for the
causes they serve.
A lack of awareness
However, a markedly different response
to the State Street/Wharton poll was
generated by calls to some leading UK
charities, asking whether ETFs form
part of their approaches to investing
their funds.
“They are higher risk than we
would want to expose ourselves to,”
said a spokesman for children’s
charity Barnardo’s.
At the Royal National Lifeboat
Institution, there was a similar story.
“No, we don’t use ETFs,” said
spokesman Spencer Gammont. “With our
prudent investment position, we probably
wouldn’t want to use them at the moment
and we certainly would not really be
looking at a new vehicle.”
Alison Jestico, head of UK finance at
Oxfam, added: “I am not aware of them
and we are not using them.”
Andrew McLaughlin, spokesman for the
National Trust, said that the charity does
have “small investments in this area” but
was unable to comment further.
Massive growth
So why are charities so resistant to
using ETFs as part of a prudent
investment strategy?
Misinformation and confusion about
what they are and are not could be part
of the answer.
“Exchange-traded funds saw
massive growth last year and a lot of
people are getting into them because of
their efficiency and low costs,” said one
stock market commentator, “but some
people are worried about the use of
comparatively new asset classes
at the moment, because of what’s
happening to hedge funds in the
economic downturn.”
Perhaps.
Guy Davies, head of charities at
Evercore Pan-Asset Capital Management,
says the trend to ETFs is quite the
reverse.
“The popularity of fixed income
and commodity based ETFs has seen net
sales of US$62bn in Europe for the first
10 months of 2008 compared to mutual
fund redemptions of US$506bn according
to Lipper Feri fund analysis.The number
of ETFs during this period has increased
by 31% and assets under management
globally stood at US$634bn by the end
of November.”
Short-term speculation
But exchange-traded funds certainly have
their detractors in the stock market, such
as John C Bogle, founder of America’s
Vanguard Group, a leading issuer of
index funds, which has diversified into
ETFs since his retirement.
Bogle argued in the Wall Street Journal
in February 2007 that ETFs represent
short-term speculation, that their trading
expenses decrease returns to investors
and that most ETFs provide insufficient
diversification.
Other market observers
have claimed that ETFs can be
used to manipulate market prices,
including use of them for the short-selling
that some commentators still blame for
the stock market collapse of 2008.
Although Davies puts the case for the
defence. “The article John Bogle wrote
criticses those ETFs that were narrow in
investment, for instance replicating an
industry sector or a subset of an index
rather than the broad market itself, such
as the FTSE All Share index.
“As founder of the Vanguard index
funds, John Bogel believed in minimising
portfolio turnover, lower costs and long
term holding of such funds. He was
concerned that these specialist ETFs
would encourage short term trading
and higher commission for brokers.”
While any investment may encourage
speculators, the ETF market has
developed significantly since February
2007 almost doubling in terms of assets
and funds, to meet investor demand.
“Charities by their nature tend to have
long term investment horizons and we
favour ETFs that replicates broader
market indices at low costs. However, not
all ETFs are exactly the same, with
differing investment profiles and costs, so
trustees should always take professional
advice before buying,” says Davies.
Some critics have also argued that
ETFs offer little or no advantage for taxdeferred,
long-term retirement investors
because such investors typically conduct
little, if any, trading.
ETF holdings
However, the claim of significant
growth is certainly true, especially in
the US.
According to figures from the
Investment Company Institute, as at
May 2008, there were 680 ETFs in the
US with a total $610bn of assets – an
increase of $125bn over the previous 12
months. Globally, there are estimated to
be 1,500 ETFs.
In Europe, Dan Draper, global head
of Lyxor ETF, the exchange-traded funds
brokerage of French banking group
Societe Generale, says his firm accounts
for Eu24bn of ETFs – 26pc of the
European market, which totalled
Eu91.1bn in 2008.
According to Draper, the European
ETF industry increased by 6.5pc in 2008,
citing figures from Lyxor, which is secondplaced
in European ETF, behind Barclays
Global Investors, which is market leader
with a share of 38pc.
So what are ETFs and how do they
operate. Basically, ETFs are index-linked
funds tradable in real time during market
hours just like ordinary shares.
An ETF holds assets such as stocks
or bonds and trades at approximately the
same price as the net asset value of its
underlying assets over the course of the
trading day.
The objective is simple: to replicate
as closely as possible the performance
of an index or of a selection of stocks.
Most ETFs track an index, such as the
Dow Jones Industrial Average or the
S&P500.
ETF issuers pride themselves on
products that are easily accessible and
flexible, saying this makes them the
perfect tool for investors to implement
their investment strategy.
Misconceptions
So what is the explanation for the asset
class being virtually ignored by the UK
charities sector?
Draper says this is a UK phenomenon,
fed by misconceptions about the risks of
the instruments and confusion with
exchange-trded commodities, which are
derivative products enabling much more
potential exposure to risk.
“I think ETFs are just not yet very well
known by the UK charities sector,“ he says.
“I have never heard of any UK charities
using ETFs but the use of ETFs is
significant in the US market for charities
and endowments.
“In the UK, it is surprising that they are
so little-used by charities but we are
seeing more usage of them in Europe
generally.
“There’s a misconception that they are
riskier than other investments it it comes
down to what you sort of ETF you buy. If
you buy one that tracks the S&P500, it
will be no more or less risky than the
performance of that index itself. ETFs
simply hold products and indices.”
Terry Gyorffy, of the charity investments
team at Barclays Wealth, adds: “There is
a lack of understanding and information
about ETFs among UK charities, who
have a limited experience of the
investments.
“There has also been a failure of
investment managers to advise aout
the opportunities that ETFs present
and there have been difficulties for
charities in implanting their ethical
investment policies with some ETFs.
For example you can’t take tobacco
out of a FTSE100 index ETF.
“However, a growing number of ethical
ETFs are now becoming available.”
Davies adds: “Increasingly, investment
managers are using ETFs in charity
investment portfolios to gain exposure to
assets they are neutral to or less liquid
assets such as commodities.”
Strategic asset allocation
ETFs have been available in the US
since 1993 and in Europe since 1999,
traditionally as index funds, although
America’s Securities and Exchange
Commission began to authorise the
creation of actively-managed ETFs
last year.
Supporters say their efficiency stems
from the fact that ETFs behave like
stocks or closed-end funds, with their
prices transparently available throughout
the course of a trading day. Traditional
mutual fund or unit investment trusts, in
contrast, are valued and purchased or
redeemed at the end of each trading day.
This means the ETFs can have a lower
tracking error rate than traditional index
funds, while the intra-day pricing can
produce better prices.
Gyorffy says the use of ETFs also
focuses importance on strategic asset
allocation, rather than stock-picking within
investors’ portfolios and puts less reliance
on investment managers to consistently
outperform the markets. “Use of ETFs
means that you own the market,“
he adds.
ETFs in the UK are regulated by
the London Stock Exchange while ETF
issuers are regulated by the Financial
Services Authority. ETFs can also pay
dividends and are exempt from UK
stamp duty.
One of their main benefits, however, is
their cost. Lyxor, for example, typically
charges an annual fee of 0.3pc-0.4pc a
year for ETF accounts, plus commission
for dealings, Draper reckons industry fees
range from 0.15pc to 0.85pc a year.
ETFs champion
He believes that ETFs need a champion
in the UK charities sector in order
for other not-for-profit organisations
to recognise their merits and begin
using them.
Indeed, the popularity of ETFs in the
US surged after they were very publicly
embraced by David Swenson, head of the
Yale University Endowment, the second
largest US university charity after the
endowment at Harvard.
“In Europe and the UK, there has
not been anyone like David Swenson
popularising the instruments,” says
Draper. “There needs to be someone
important in the UK who does the same
for the rest of the sector to follow.
“It’s just a matter of awareness in the
UK industry of how they work and this is
just starting to happen in the UK as the
merits of ETFs become better understood.”
Davies agrees. “We are seeing more
providers of ETFs enter the market in the
UK and firms like Evercore Pan-Asset
Capital base their business around the
use of asset allocation for charities,
primarily using ETFs to gain exposure to
investment classes.”
A SHORT GUIDE TO ETFS
ETFs are exchange listed transparent
open-ended investment funds which can be
bought and sold at any time. It is a basket
of securities that trades like a single stock.
This means that it provides the benefits of
a collective investment vehicle and the
benefits of owning an individual share.
Benefits include the diversification through
just one ETF share charities can gain
diversify market exposure, and liquidity as
ETFs trade in real time on stock
exchanges, they are liquid and can provide
greater investment flexibility than mutual
funds, which tend to trade only once a day.
Charities, foundations and endowment
funds in the US have been investing into
ETFs since 1974. Although, first
introduced on the London Stock Exchange
in 2000, ETFs have taken a while to gain
attention from investors.
This mainly stems
from the traditional investment approach
many charities have taken which focuses
on active stock selection as the means to
gain returns rather than active asset
allocation. Their popularity with UK
charities has recently increased as ETFs
have been used for asset allocation directly
by endowment funds, such as Oxbridge
colleges.
As at the end of November 2008,
there was US$633bn of assets in ETFs,
managed by 86 managers on 42
exchanges around the world. While assets
fell by 20.4% in the year, it was less than
the 43.8% fall in global stockmarkets,
reflecting the 31% increase in the number
of ETFs during the period, according to
Barclays Global Investors. Morgan Stanley
estimates that global ETF assets under
management will exceed US $2 trillion by
2011.
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