Warren Buffet backs low cost funds

Warren Buffet backs low cost funds – ETFS – Exchange Traded Funds

Predicting rain doesn’t count. Building arks does – Warren Buffet

EFTS – Exchange Traded Funds are quickly becoming the darlings of the financial world and are, in fact, even coming to dominate it. What used to be a relatively niche sector, is now rapidly becoming one of the biggest games in town – they now even have Warren Buffet’s blessing and seal of approval. Trading in Apple shares is worth over £3 billion a day. However, that pales into insignificance with the £14 billion, which is traded daily in the shares of State Street’s SPDR 500 fund.

Today, the buying and selling of ETF’s accounts for almost 90% of all US trading in US stocks. Recently Warren Buffet had announced that 90% of the money, he would bequeath to his wife would go into a low-cost US tracker fund.

How do ETF’s work?

According to a recent Times article, ETFS have a similar purpose to index tracker funds — they aim to replicate the performance of a particular stock market index, such as the FTSE 100 in the UK.

However, while a tracker fund is priced only once a day, an ETF is traded on a stock exchange and can be bought or sold at any time during normal working hours, making it more flexible and more liquid than a conventional tracker fund.

Exchange-traded commodities (ETCs) are similar, performing the same tracking function for commodities, such as gold. The simplest way of doing this is to hold the commodity in a tangible form, such as gold bullion. This is known as a physical ETC.

The alternative approach is to use derivatives to capture the rise and fall in the price of a commodity. These are known as synthetic ETCs. Some ETFs may also adopt the synthetic approach, rather than buying all the stocks in a particular index.

Are they expensive?

No, they are not expensive at all. ETF’s and ETC’s are both traded on the stock exchange – in exactly the same way as any other share and investors invest in them through a broker. They will have to pay a dealing commission, although this can be a flat fee of as little as £10. There will also be a small spread, usually a fraction of 1 per cent, between the buying and selling price of an ETF, plus an annual charge levied by the ETF itself, which will normally be in the range of about 0.2 to 0.5 per cent. This is comparable with the annual charge on a typical tracker fund.

However, if you want a cheap way of gaining exposure to global stock markets you can do so through ETFs from HSBC and Vanguard, which charge 0.15 per cent and 0.18 per cent respectively. Amundi and iShares offer similar access to emerging markets for 0.2 per cent and 0.25 per cent.

These charges are way below the 0.75 per cent typically charged by actively managed funds and this is one of the key drivers of the popularity of ETFs. Deborah Fuhr, a managing partner at ETFGI, the research and consultancy company, says: “This is a rare example in the financial world where private investors benefit from paying the same low level of charges as institutional investors.”

What is the best way to make the most of them?

Mark Atherton, in The Times has this to say on the topic, “Justin Modray, of Candid Financial Advice, the online independent adviser, says the vanilla approach is to use ETFs, like tracker funds, as a way to gain cheap exposure to a particular market, such as the UK or Europe, or a commodity, such as gold or oil. However, the options available go far beyond that.

Nizam Hamid, the head of strategy at Wisdom Tree Europe, which runs a range of ETFs, says: “There are sophisticated products that cover an index, such as the FTSE, but then give it a particular tilt, for example by focusing on income-producing stocks. We have an equity income ETF that offers exposure to about 100 companies with an average yield of 4.7 per cent — significantly higher than the market as a whole.

“In the same way, we have a Europe Equity ETF that seeks to benefit from the strong dollar and weak euro by focusing on stocks, such as LVMH, L’Oréal and BMW, that generate more than 50 per cent of their revenues outside of Europe. Importantly for UK investors, it is available with a sterling-hedged share class, which protects investors should the pound strengthen against the euro.”

Another tactic that adventurous investors can adopt is to buy “short ETFs”, which make money when a particular index or commodity falls in value. They can be used either as a straight one-off bet on a particular market going down or as a way that long-term growth investors can hedge against short-term market falls.

For those investors with real nerves of steel there are also leveraged ETFS, which have a multiplier effect on returns. For example, on a two-times leveraged ETF any rise or fall in the index would be doubled in value, providing scope for spectacular gains — or spectacular losses.

Mr Khalaf says: “These types of ETFS are very risky and we would warn investors to be very careful before putting any money into them.”

What are the pitfalls?

ETFS are, to a certain extent, blunt instruments. They buy all the shares in a particular index and don’t attempt to discriminate between the good and the bad.

Another problem, says Mr Modray, lies in the use of derivatives for so-called synthetic ETFS. He says: “With these derivatives the ETF manager is dependent on a third party to deliver the hoped-for return. This risk, known as counterparty risk, might seem fairly remote if the third party is a large investment bank, but, as the fall of Lehman Brothers showed us, large investment banks can fail.”

A further drawback to consider, he says, is that ETFs are shares and, as such, do not enjoy the protection of the Financial Services Compensation Scheme.

Conclusion

If Warren Buffet is backing these things – especially for the small investor…then they certainly get my vote. The costs are reasonable and as there is a fight, to drive down the costs, going on between the bigger financial groups, which are offering ETFS, such as BlackRock, Vanguard and Source…they can only, over time, become cheaper still.

You can buy an ETF tracking the US S&P 500 index from Source for 0.05 per cent, while BlackRock’s iShares, Vanguard and DBX-trackers offer access to the US stock market for an annual charge of 0.07 per cent. You can invest in the UK’s FTSE 100 index for as little as 0.07 per cent with ETFs from HSBC and iShares. (Source: The Times Money: 17/12/2016)