Know your onions when it comes to ETF’s

28th June 2013

For those readers not in the investment world and not familiar with the acronym ETF’s, it stands for ‘Exchange Traded Funds’, in simple terms they are trackers. In other words they track the performance of an index (such as the FTSE 100) either up or down.

Some argue that ETF’s are better than actively managed funds in terms of longer term performance as most fund managers tend to miss the point at which a market starts to pick up and some will argue that Actively managed funds are better as the fund manager can react when a market is falling by selling some holdings to reduce the risk etc, whereas trackers will do what they say on the tin and track the market all the way down as well as all the way up.

Another bone of contention has always been around the costs/charges when comparing an ETF to an Actively managed fund and up until 1st January this year, I would have found in favour of ETF’s in the majority of cases (if the investment decision was purely based on price). However, since the 1st January this year when the FSA’s Retail Distribution Review (RDR) was introduced and as a result most fund houses have now made available ‘clean’ & ‘super clean’ share classes (lets not expand on this bit of jargon at this point, or we could be here all day as this probably warrants another article all of it’s own) the argument based on cost alone is fairly neutral.

For those who still prefer ETF’s (for whatever reason) it pays to know your onions! as they are not all the same.

Running an ETF from the fund houses point of view can be very complex, for example, the indices themself don’t account for the transaction and management costs associated with running a fund, so an ETF is always going to slightly underperform the index it is tracking due to the charges/fees drag.

The other major complexity is how the ETF is structured, in other words, should it fully replicate the index it is tracking (this could be very expensive unless you have scale. To buy every company in the FTSE 100 for example everytime someone invested into the ETF would mean 100 separate trades).

There are essentially 4 ways ETF’s are usually structured, and before you invest you should be aware of which type you are investing…………….

1. Full Replication

Some managers aim to fully replicate the index, which means holding every stock in the same percentage as it is represented in the index. When the index rebalances, so too will the fund – this ensures the accuracyof portfolio holdings, but it can also limit flexibility.

Full replication is perhaps the purest method of index tracking, and it should produce a low tracking error. However, it can also be very expensive, since the transaction costs tend to be high for illiquid stocks. Fund size is therefore crucial, because larger funds are able to benefit from the economies of scale and minimise the impact of individual transactions to make the methodology viable.

2.Stratified Sampling

Rather than attempt to hold all of the stocks in an index at the exact weightings, some ETF’s hold a representative sample of the market – a strategy known as ‘Stratified Sampling’. Shares are selected by dividing the index into sub-groups (say, by industry sectors for equities, or by maturity bands for bonds), and representative samples are taken from each.

The objective here is to create a portfolio that mirrors the characteristics of each sub-group – and which, collectively, will also represent the whole market and therefore track the market index. This can be achieved using computer based models, but, compared to other methodologies it tends to have greater human interaction in the selection of the representative stocks.


This is often described as the ‘black box’ technique of passive strategies, because computer or statistical models are used to make buying and selling decisions. In this form of sampling, mathematical models, based on historical data, are used to construct a portfolio that aims to track the chosen index.

This approach is not easily adaptable to a changing investment environment and it will always play catch-up with the market. It is, however, the cheapest type of ETF to operate.

4.Synthetic Replication

I know this sounds like some sort of special persil or arial washing powder, but rather than buying the physical securities, the ETF can use derivatives to obtain ‘synthetic’ exposure to an index.

This method is generally more complex and leads to other risks, such as ‘counterparty risk’ i.e. who is actually standing behind the derivative and will they still be there when it’s time to pay out?

This is certainly the riskier method but by using derivatives some ETF’s are able to offer a return of an index x 2 etc as they are leveraging to increase exposure but this can also work in the opposite direction, so please beware and remember the old saying….”if you play with fire, you are likely to get burnt”

In summary – when it comes to the active vs passive argument there is no clear winner between actively managed funds or ETF’s, it just depends on the style of management you prefer and the markets you want exposure to.

However, it pays to know your onions before choosing an ETF to ensure you are comfortable with the underlying investment method being employed.

Are you a rational Investor?

24th June 2013

There is much discussion and debate in the investment world among fund management companies, psychologists and investment advisers regarding the subject commonly known as ‘Behavioural Finance’. So what is it and why should you be aware of it?

What is Behavioural Finance?

Behavioural Finance is a field of study which attempts to identify, understand and explain the human psychological and emotional factors that influence investors reasoning and decision making process. If we do not apply rational perspective when investing, we leave ourselves vulnerable to the impact of our own emotions, which may mean investing on an irrational gut instinct rather than underlying facts or fundamental principles.

Some of the reasons

Many investors base the price they are willing to pay for an asset on their perception of its immediate potential, focusing on short term newsflow and forecasts. However, these factors distract from the fundamentals, preventing the investor from viewing the investment as a long-term asset. This means that decision making is often based on irrational impulses, fuelled by common human psychological traits which cause us to form several kinds of emotional or cognitive biases, some of which are listed below:

Anchoring – Our tendency to rely too heavily on one specific piece of information, such as the price a stock use to be and so we assume it will get back to that point again.

Confirmation Bias – Where we only pay attention to information which supports our existing view, and discount anything which opposes it.

Overconfident Bias – An overly optimistic assessment of our own knowledge or abilities (often fed by Hindsight Bias – believing after an event that we could have predicted the outcome or “I knew it all along” bias).

Herd Behaviour – Where we follow the actions of the group, even if individually we may have recognised their actions as irrational, this is surely evident in the way markets always over-react to either good news or bad news then usually steadies out over the next few weeks. A good example of this, has to be the DotCom boom, surely with so many IT companies not even making a profit back then, it must have been obvious that to invest was an irrational herd mentality? It all seems obvious now in hindsight.

Behavioural Finance Affects Markets

Theories in ‘traditional’ finance, such as ‘Efficient Market Hypothesis’ (EMH) which asserts that markets are fully efficient and cannot be beaten as asset prices reflect all relevent information which is known by all buyers and sellers at all times, assumes that investors always behave rationally and logically. We know that this is not true of human nature.

Behavioural Finance identifies that people systematically make errors of judgement when they form investment decisions. When these mistakes become repeated throughout the investment community, they cause illogical price movements in assets. Such inafficiencies can offer a window of opportunity to those who recognise what is driving these price movements, and develop strategies to exploit them.

A notable episode of behavioural finance at play came in 2011 when an earthquake and tsunami hit Japan. While it could be expected that Japanese equity markets would fall after the disaster, European equity markets dropped equally as sharp – even though investors had little information on the likely impact of such a far-flung event on, for example, German companies.

How can Understanding Behavioural Finance help investors?

The principles behind behavioural finance sound straightforward enough, but how can they be used to construct and manage an investment portfolio?

One approach is to be objective and investigate scientifically how much you are being paid to invest in a particular asset. By comparing the yield provided by say, a government bond to that of a company share, an investor can objectively evaluate the relative attractiveness of each asset. However, this process has to be disciplined; the investor cannot be swayed by the sentiment surrounding each asset. In other words just because everyone is selling commodity funds at the moment or buying gold should not have any effect on your final decision.

Not every investor will be comfortable with following the rules of behavioural finance techniques. It can feel very lonely and as if you are being a bit risky when taking decisions that fly in the face of the norm (or should I say, not following the herd)

Nevertheless, the principles of behavioural finance can be harnessed by any investor willing to accept that a sizeable proportion of market movements can be attributed to noise rather than hard facts.

Ultimately, behavioural finance does not seek to ignore the human factor. Rather, it seeks to recognise it, acknowledge it’s important influence, and then strip it out of the analytical process in order to make successful long term investment decisions. After all, wouldn’t it be nice to have been invested in something from the beginning of it’s rise (such as gold) as oppose to be jumping on the band-wagon and following the herd because you read in the Daily Mail how everyone is investing in it and believing all the hype that it protects you against inflation!

The Power of Dividends

21st June 2013

High dividend paying stocks offer two things to the investor: a source of income that currently exceeds that available from US, UK and core Eurozone government bonds or cash accounts, and, secondly, a valuable good hedge against potential rising inflation.

For the income seeker, dividends can provide an attractive source of regular income payments that have the potential to rise in line with increases in inflation, as the underlying companies tend to raise the price of their goods or services in line or above inflation and therefore should look to move their dividend paying policy in the same way. For the capital growth seeker, it is dividend growth and the reinvestment of dividends that often provides stock market investors with the greatest proportion of their overall long-term return.

Dividends for the income seeker

Investors looking for income have traditionally sought the security of risk-free government bonds or fixed term deposit accounts at their local bank. But with yields on the most favoured government bonds often below inflation and the price being demanded for this income, has lead many income seekers to start looking to the equity market to provide an attractive level of income.

The traditional relationship between equities and government bonds, which existed in all the major markets in previous decades, was for the equity dividend yield to be lower than the government bond yield to compensate for the capital gain offered by holding equities. But this relationship has been inverted – in some cases sharply – in recent years.

Income from government bonds in those markets viewed as the safest, is at ultra low levels because of the currently prolonged period of low growth. However, this environment can be positive for higher yielding equities.

First, dividend paying stocks are supported by strong demand given the lack of attractive alternative income sources. Second, high dividend paying stocks are often found in the defensive sectors most able to withstand negative economic shocks.

Dividends for capital growth

Meanwhile, for investors seeking capital growth, dividend stocks are also appealing. The power of compounding means that reinvesting dividends over a sustained period provides a powerful boost to total returns. Over the past decade, for example, the return on the MSCI World Value Index (a good proxy for high dividend stocks) was 47% without reinvested dividends, but 105% if dividends were reinvested (source: Factset, data to 30th November 2012).

Dividends have also been the main driver of market returns over the long term. In each decade since the 1920s, dividends have contributed positively to investors’ returns, providing stability to portfolios and helping to limit losses when markets are falling (source: Factset, Standard & Poor’s).

Dividend-paying stocks can therefore play a dual role in a portfolio: to provide income, particularly in a world of very low interest rates and core government bond yields, and to provide a valuable source of total return over long investment horizons.