The rapidly increasing range of ETFs available means investors need some guidelines on how to make a suitable selection, says Jason Britton of T Bailey.

The exchange traded fund (ETF) universe is getting ever bigger – latest figures show there are now somewhere in the region of 2,300 ETFs. This has opened up choice for the passive investor but this diverse universe means they are faced with the same dilemma as any active fund picker: which funds to choose?

Do your homework

More research is required than many may first think. There are several issues an investor or their adviser needs to consider. For example, an ETF domiciled in the US that does not have distributor status is subject to withholding tax and its returns liable to income tax rather than capital gains tax (CGT).

Investors buying such an ETF directly who had not done their homework could be in for a nasty shock. Research carried out by BlackRock earlier this year revealed a quarter of UK-listed ETFs could leave investors open to income tax rather than CGT.

Although charges on ETFs are typically low, one should not assume this to be the case. The most extreme example listed in the UK that we have seen recently is the MW TOPS Global Alpha which has a total expense ratio (TER) of 175 basis points.

What’s under the bonnet?

There are also risks inherent in the structure of ETFs. Many providers lend stock to make extra money. In the ordinary course of business this is fine. But if stock had been lent to Lehmans before it went bust what would the fallout have been? Since the demise of Lehmans exposure limits are being better monitored but credit risk still exists.

ETFs have the capacity to be fairly complex – investors can now choose from specialised baskets of stocks focused on particular sectors or regions, as well as leveraged and even inverse ETFs. In some cases this can open up more issues such as collateral and counterparty risk.

Rather than buy the basket of shares they are tracking, some ETFs are structured to enter into a swap with a counterparty, typically an investment bank, which promises the return achieved by the relevant index in exchange for security on most of the assets within the ETF. Investors need to ask what the make-up of this collateral is.

Choosing between ETFs and trackers

For supporters of passive investing there is also the issue of when to choose between ETFs and index trackers. Here again there are important issues to consider. An ETF can be traded at any time of the trading day, whereas an index tracker fund can typically only be traded at one point in the trading day. This may have implications for the active investor keen to time market entry and exit points.

Using an ETF allows you to implement trades very quickly, intra-day. For very short-term tactical moves, given the ability to trade intra-day, a portfolio manager may prefer the flexibility of using ETFs over trackers.

There is constant debate on the question of active versus passive investment. But to our mind this argument is passé. There is a good case for combining both. The questions revolve around how much active and passive to have in a portfolio and how best to manage and deliver that mix.

Adopting fund of funds model

This year we have begun to see the fund of funds model applied as successfully to this challenge as it is in the active arena, enabling advisers to access actively managed portfolios of low-cost passive investments.