Is passive right for you?
Starbucks and the Big Mac, iPads and iPods, Ford cars, the compensation culture, Elvis Presley and Michael Jackson. The United States of America has given us a lot over the years, from the calorific to the innovative, the entertaining to the unsavoury.
The trends that sail across the Pond from Uncle Sam and infiltrate our small island also extend to politics and business.
Our last general election had a presidential edge to it, as the party leaders were beamed into our front rooms. Even our personal finances are taking on an American sheen.
Our pensions could soon look more like the 401(k) retirement pots in the States - the government is considering making pensions more flexible by allowing us to take money out of our pensions before we retire.
Our investments are also slowly subscribing to the long-held American view that lower cost, passive strategies work.
Exchange traded funds first launched in the US in 1993; the industry is now worth $741 billion (£475 billion). In the UK, we have nine ETF providers in an industry worth $54 billion. Non-ETF passive funds are also more prevalent in the States than in the UK.
It's obvious that the passive sector here is following the American example and growing - new players, such as HSBC, have moved into ETFs and tracker funds are launched every month.
What is not so obvious is that passive investing is shedding its dull image.
While the majority of our ETFs fall into the 'plain vanilla' camp, such as tracking a well-established index, like the FTSE 100 (UKX) or S&P 500, or following the price of a commodity, some rather interesting ETFs have also popped up, and more are on the way from their birthplace.
Sophisticated 'pseudo active' passive funds are booming in the States. Dividend trackers and hedge fund ETFs are the new big thing.
Indeed, Powershares, the ETF arm of Invesco, boasts five 'actively-managed' ETFs in the US, such as the Active Mega Cap fund.
Passive funds aren't normally thought of as income generators, but one of the latest innovations - dividend-weighted index tracking funds - will be of interest to hard-pressed income-seekers.
Indeed, if you want income but are struggling to get a decent return on your cash, plus you like to keep charges to a minimum, then these could be for you.
There are a few available in the UK: the iShares UK Dividend Plus ETF, the Lyxor Euro Stoxx 50 Dividends, two ETFs from db x-trackers and the small Munro fund.
What's out there
The iShares ETF was one of the first dividend-weighted passive funds in the UK, launching in 2005. It tracks the performance of the FTSE UK Dividend+ index.
The index selects the top 50 stocks by one-year forecast dividend yield (from the FTSE 350, excluding investment trusts) and the constituents' weightings are determined by their dividend yield, as opposed to market capitalisation.
The £310 million ETF has a 0.4% total expense ratio (TER) and pays out income quarterly. The distribution yield is currently 4.66%.
Fundamental Tracker Investment Management's Munro fund is a similar vehicle, although it uses its own formula to extract the FTSE 350 companies that have the highest forecast gross cash dividends.
It also has more holdings - currently 113. There is no initial charge for investing in the fund directly and the annual fee is 0.5%.
Rob Davies, managing director of Fundamental Tracker Investment Management, notes: "We are a fan of using dividends for two reasons. Firstly, they provide 90% of the return from equities and, secondly, they are externally verifiable via a cheque."
The last few years, however, have been a sorry time for dividend payouts in the UK. Indeed, the Munro fund's largest holding is BP and it is unclear when the oil major will resume its dividends.
Investors looking for a more diversified approach should look at Lyxor's Euro Stoxx 50 Dividends ETF, which is weighted to European (ex UK) dividend-paying companies. Lyxor, part of Société Générale, launched the ETF in May.
It tracks the Euro Stoxx 50 Dividend Points Futures index, which in turn is composed of five Euro Stoxx 50 index dividend futures contracts. The futures take a position on the dividends that will be paid each year by the companies in the Euro Stoxx 50.
However, being a futures-based product, the ETF tracks the index and does not pay out dividends as income. The dividends are given back in the total return.
In July, it delivered an 11% return but in August it was down 1%. The use of futures means the TER is quite high: 0.7%.
Db x-trackers also boasts two dividend ETFs. The Euro Stoxx Select Dividend 30 ETF follows the index of the same name, which covers the highest dividend paying companies in the eurozone (excluding Slovenia).
The fund currently has its highest geographic allocation to Germany (23.7%) and highest sector weighting in financials (29.3%). The dividend yield is 3.67%, and the TER is a low 0.3%.
Its other ETF offers even more diversification as it tracks the Stoxx Global Select Dividend 100 index.
The index is defined as all dividend-paying companies in the Dow Jones Stoxx Global 1800 index that have a positive historical five-year dividend-per-share growth rate, and a dividend-to- earnings-per-share ratio of less than, or equal to, 60 or 80%.
Stocks are ranked by their net dividend yields. The largest holding in the ETF is Man Group.
So this is different to some of the other dividend-weighted funds as it uses historical dividends, rather than forecasts.
The db x global dividend ETF spent most of its time going down in value after it launched in June 2007, but since the start of last year performance has picked up.
Over the past 12 months it has increased 11%. The dividend yield is 5.62%. So the yield is higher than db x's European ETF but it comes at a price, as the TER is 0.5%.
Dividend-hungry investors could soon be rewarded with more choice. Wisdom Tree, the top dividend index firm in the US, is planning to expand globally and is rumoured to arrive in the UK this year.
And Davies has lots of ideas for other funds, although "they'll have to wait until the Munro fund is firmly established".
Dawn Mealing, head of investment proposition at Bluefin Wealth Management, says the idea of dividend-weighted trackers is interesting.
"It is too early to say how the concept will develop but the increasing inflows into the early dividend-weighted funds suggest that the current momentum will fuel a growing demand in this area," she says.
Roddy Kohn, managing partner of KohnCougar, also spies demand for the funds. "I can see increasing demand for equity income, especially considering the low level of interest earned from cash," he says.
Kohn says there are pros and cons with the new breed of ETFs that follow 'man-made' indices.
"Even though the fund tracks an index, the index is based on dividend forecasts, which must have been provided by 'someone'. You are therefore not strictly purchasing a fund based on market forces.
"This however is a good thing, as a dividend-weighted tracker based on historic yield could be very risky indeed. The cons are that the dividend forecasts provided by outside agencies could be false."
If a passive product starts to adopt active tendencies then clearly the risk level will increase. But most of the advantages of passive over active will still hold true.
For example, the new breed of dividend-weighted trackers will still avoid the big risk of star managers leaving: investors in Gartmore's smaller companies funds and trusts will still be reeling from fund manager Gervais Williams' shock departure on 1 September.
And they are still much cheaper than active funds, even if they are dearer than some of the simpler tracker products.
Hedge fund ETFs
Hedge fund ETFs are another innovation. A small firm in the US called IndexIQ has been busy pioneering hedge fund replication indices; they basically turn active management thinking into a set of rules to create an index to reproduce the returns that would have come from having an active manager.
Adam Patti, chief executive officer of IndexIQ, tells Money Observer: "We offer a liquid alternative to traditional hedge funds, but without the lack of transparency and high fees."
IndexIQ offers three hedge fund replication ETFs, all listed in the US, and with a 0.75% TER. Patti says he has had his "hands full" since launching IndexIQ's first ETF last year, but in the next two years the company may expand globally.
There has already been appetite for the strategies from outside the US, with some funds in Europe buying the ETFs.
Investors looking for London-listed hedge fund ETFs have products from db x and Marshall Wace, one of Europe's largest hedge funds, to choose from.
The db x Hedge Fund Index ETF claims to be the first ETF whose underlying constituents are actual hedge funds. So this is quite different to the replication model used by IndexIQ.
The db x ETF tracks the db Hedge Fund index, which is made up of five hedge fund strategies.
Db x says the "maximum annual fee" is 0.9%, however there are underlying fees - a 1.5% annual fee and a performance fee of between 15 and 20% - which are passed on to the investor through reduced returns.
The Tops Global Alpha ETF tracks the six existing Marshall Wace Top hedge fund strategies. It has a 0.25% annual charge, a 1.5% annual fee, triggered by the underlying investment, and a 20% performance fee.
This still works out cheaper than buying hedge funds directly, but is an example of where the 'active' element hikes up the price for passive funds.
Financial advisers also point to Dimensional Fund Advisors as an interesting development in the passive space. The firm offers equity and bond funds, domiciled in Dublin and regulated by the Financial Services Authority.
"The funds aim to deliver the return of the relevant market by a process which eschews pure index tracking in favour of a patient trading philosophy, which avoids the costs caused by market makers predicting the fund's trades and moving the price against them," explains Robert Lockie, investment manager at Bloomsbury Financial Planning and a fan of Dimensional's approach.
"The problem for private investors is that Dimensional's funds are only available via a few advisers." Bloomsbury offers the funds and although the minimum investment tends to be around £100,000, Lockie says he has dealt as low as Bloomsbury's own minimum trade size of £5,000, as the Dimensional minimum is not rigidly applied. Bluefin also offers Dimensional funds.
Mealing says the Dimensional approach is based on many years of academic research.
She says: "The Value Equity funds exploit the three main sources of risk - that equities have a higher expected return over fixed interest, shares of smaller firms have higher expected returns than shares of large firms, and the lower priced stocks that are out of favour have higher expected returns than the more popular stocks.
"Dimensional's use of sophisticated share trading means they can invest passively in stocks all over the world that have these characteristics - buying in and selling out of smaller company out-of-favour stocks automatically."
This article was originally published in Money Observer - Moneywise's sister publication - in October 2010
A way of valuing a company by the total value of its issued shares and calculated by multiplying the number of shares in issues by the market price. This means the market capitalisation fluctuates continually as the value of the shares change in the market. For example, HSBC has 17.82bn shares in issue at a price of 646.2p making a market capitalisation of £115.15bn.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
A sophisticated absolute return fund that seeks to make money for its investors regardless of how global markets are performing. To that end, they invest in shares, bonds, currencies and commodities using a raft of investment techniques such as gearing, short selling, derivatives, futures, options and interest rate swaps. Most are based “offshore” and are not regulated by the financial authorities. Although ordinary investors can gain exposure to hedge funds through certain types of investment funds, direct investment is for the wealthy as most funds require potential investors to have liquid assets greater than £150,000m.
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.