Exchange Traded Funds Catching On - Slowly

Jason Gorringe, Tax-news.com, London

30 October 2000

Exchange Traded Funds (ETFs), a new type of managed fund, have enjoyed success in the US for some time now, but they have been slow to catch on in Europe. However, this year has seen an upturn in their fortunes on this side of the pond. In the UK the first ETF, a fund tracking the FTSE 100, was launched in April and it was joined recently by a second fund tracking a new FTSE index of TMT stocks.

ETFs are mutual funds traded like a stock, and they are relatively cheap. Like shares, they can be bought and sold during market hours through a stockbroker, and like funds they offer exposure to a broad range of shares. They do not, however, carry discounts or premiums. As far as price is concerned, the new ETFs in the UK seem to be a bargain. The annual management charge on the newest one to be launched is 0.5 per cent and the only other cost is the dealing commission charged by the investor's stockbroker. There is no stamp duty levied because iShares, the subsidiary company of Barclays Global Investors that runs the UK's two ETFs, is based in Ireland.

The advantage ETFs offer over index tracker unit trusts is that there is no hefty initial charge or bid offer spread set by the fund manager rather than the market. iShares' first ETF, iFTSE 100, tracks the FTSE 100 while its second ETF, iFTSE TMT, tracks FTSE International's new TMT index. This index comprises all the TMT stocks in the 350. Currently there are 36 TMTs in the FTSE 350. No single stock can account for more than 4 per cent of the index, even if in reality they account for a much larger chunk of either the FTSE 100 or 350. The largest 10 stocks in the FTSE TMT will each represent 4 per cent of the index and the next 10 down will each account for 3.5 per cent. These
rules mean investors tracking the index will not end up overexposed to a single company, thus cutting down on the risk factor.

There's no doubt ETF's are catching on slowly. More are due to be launched in the near future by US investment management company State Street Global Advisors. It plans to introduce a range of ETFs based on MSCI indices, which will include European and sector indices such as information technology, telecom services and healthcare.

However, whilst ETFs are expected to reach U$1 trillion in assets worldwide in the next seven years, some analysts believe that there are complex regulatory, licensing and investor education hurdles to be addressed before this kind of tracking instrument becomes truly popular. Product Manager for iShares, Malcolm Smith, commented: 'It will take eighteen months to two years - or more - to educate the [European] marketplace [about ETFs]'. Smith says that countries within Europe are getting a "gradual sense" of ETF benefits, but it will take a significant amount of time to educate investors and regulators about how they are structured and sold. He added: 'One of the bigger challenges is the different regulatory structure within each country and the process to get approval.' It took Barclays nine months to launch its first ETF in Europe as it waited for UK regulators to approve the product.

As far as institutional investors are concerned, a major advantage of a US ETF is that it does not have taxable capital gains distributions, like regular mutual funds. Freddy Brausch, a lawyer and investment fund specialist with De Brandt, van Hecke, Lange & Loesch in Luxembourg, says many pension funds in Europe do not have the same tax issues as their US counterparts, and that the advantage of trading ETFs would be negligible in many countries. He said: 'It wouldn’t make sense to compromise the overall benefits of the product to adopt to local tax [issues].'

There are problems with local distribution too. ETFs are almost always tied to a stock market index, so firms that offer ETFs must enter into licensing agreements with European bourses to offer an index fund. Due to the sheer number of exchanges, this is costly and can take time. iShares aims to counter this problem by phasing in the launch of ETFs throughout Europe. The firm plans to launch individual country and sector funds first, and sell pan-European funds by the end of this year. By 2001, Barclays hopes to sell sector ETFs that cover all of Europe.

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