Exchange traded funds or ETFs made their debut in 1993, however, the financial crisis marked a turning point for these instruments. They are now an essential tool in the hands of both professional and retail investors, as they are driving big changes in the field of investment management.
ETFs can be defined as open-ended investment funds, traded and listed on the major stock markets. They have become the go-to instrument for investors seeking instant, liquid exposures to markets around the world, with a relatively cheap and transparent way to buy companies for the long haul. Like individual stocks, ETFs are traded in real time at a price determined by the live valuations of the underlying investments.
As ETFs become more liquid, their bid-ask spread narrows, making them easier and more practical to trade. Bid/ask spreads for all securities tend to widen in times of market uncertainty as risk and illiquidity rise.
During the recent bout of volatility due to the COVID-19 pandemic, spreads on ETFs widened efficiently in line with the market.
These instruments offer the end investor ways to diversify risk which reduces stock-specific risk and thus reducing volatility of the overall portfolio. They offer many benefits and, if used wisely, are an excellent vehicle for an investor to achieve the investment goals set. Along the years ETFs have grown to be more sophisticated and now are available to suit almost any taste, style, asset class or industry.
The traditional ETFs are passive investment vehicles, tracking a particular index consisting of various asset classes such as stocks, bonds or commodities. Others invest in precious metals such as gold, while more esoteric offerings can be designed to mimic the fluctuations of something intangible such as market volatility.
While many investors focus on how well an ETF tracks its underlying index, a growing number of products have come to market in the past three years that have no underlying index to passively replicate. Large active management firms are now offering actively- managed ETFs by selecting securities based on the market environment and proprietary analytics, with no set schedule for portfolio changes and, generally, without full holdings transparency. These are likely to appeal to cost-conscious fans of active management providing the same intra-day liquidity benefits.
Innovation has been the hallmark of the ETF industry and they will most likely continue to be the success story of the wealth management industry
Many fund managers are focusing on actively managed thematic ETF strategies, specialising on megatrends and next-generation companies, positioned to benefit from industrial innovation, genomics, shared technologies and Fintech trends. Megatrends are the irresistible waves of change that are transforming the economic, social and political fabric of the world.
Megatrends go beyond traditional sectors and geographic focuses; they look at stocks across industries in areas like artificial intelligence, electric cars, automation and robotics. Investors are also showing more interest into socially responsible investment strategies that target environmental, social and governance (ESG) principles.
The coronavirus pandemic has reshaped the world as we know it and it may have even changed the way investors look at ETFs. Like the pandemic itself, the demand for such products is spreading. Many ETFs are also UCITS compliant, thus an investor who is eligible to pay tax in Malta may opt for the 15 per cent final withholding tax to be deducted at source from any income received or realised capital gain.
Innovation has been the hallmark of the ETF industry and they will most likely continue to be the success story of the wealth management industry, as investors look to add better diversification at a low cost into their portfolios. The core-satellite approach can be achieved via the ETF universe, whereby the traditional broader ETFs can be used to build the core part of the portfolio with a long-term horizon, focusing on the beta-related performance, while thematic and sectorial actively-managed ETFs can be tapped for the satellite component, aiming to generate alpha.
Investors should work with their financial adviser to ensure that their portfolios are properly risk-managed and well-positioned to achieve their investment objectives. Volatility is likely to remain elevated as markets and economies continue to contend with the implications of the COVID-19 pandemic. ETFs nowadays are versatile enough that they can offer portfolios enhanced risk management, liquidity and diversification during turbulent times.
This article is not, and nothing in it should be, construed as an offer, invitation or recommendation in respect of investment products or services offered by the BOV Group. ETFs may be affected by changes in currency exchange rates. Past performance is not a guide to future performance.
Rosemarie Bugeja, Senior financial adviser, BOV Wealth Management