Is passive right for you?

Published by Ruth Emery on 19 October 2010.
Last updated on 20 October 2010

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

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