Evercore Pan Asset

I was first attracted to Exchange Traded funds by their simplicity and low costs. As a long standing advocate of indexing investments in efficient, complex and foreign markets for a variety of good reasons, the advent of the ETF was manna from heaven. Here at last was a freely tradable investment that enabled you to buy into Chinese equities or Emerging markets shares or the Standard and Poors 500 Index at low cost with great flexibility.

A good ETF is transparent – you are buying the underlying components of the index or investments that will produce the same results as the index. That means you know what you are getting.  It is liquid. You can buy and sell your ETF any minute of the day that the markets are trading. If no-one wants to buy it, the manager of the ETF will sell the underlying shares to give you money back based on the value of the portfolio. It is low cost. The fees charged are low by the standards of investment funds, with fees as low as 20 basis points on the biggest markets, rising to 50 or occasionally as high as 85 basis points on the more esoteric. These fees in turn may  be largely offset by other revenue from the investments in the funds, producing practically no tracking difference compared to the return on the index after all costs for the best of these funds.

The simplest ETF is the one which replicates the index by buying all the shares in the chosen index in the right proportions. There should then be little tracking error, as the portfolio matches the index. The fund needs to offset its transaction and management costs to the best extent it can. A more complex way of doing it is to buy a portfolio of shares which nearly matches the Index, and then to top up the fund with a contract for difference to bring the performance into line with the chosen Index. These ETFs are limited in how much they can commit to a contract for difference – never more than 10% of the fund and usually much less – to ensure near index performance. We monitor such funds to watch how well they do, to manage counterparty risk, and to check the performance keeps close to the index.

These simple ETFs normally do what it says on the tin. They track their indices very closely. BlackRock iShares S & P 500 for example has only lost 0.07% relative to the Index since inception in 2002. If you look instead at actively managed funds, where the management costs may be double or treble the costs of an ETF, the average experience is to fall further behind the relevant index. In many areas the average active manager manages to lose 2% or 200 basis points per annum relative to the index.

That’s why we like these funds. It is difficult enough deciding which markets to be in. That’s a decision you cannot duck and you cannot index. It’s also the decision which makes or loses you most money. Once decided, why not keep it cheap and simple?

There is now a new complication in the ETF universe. The active managers are trying to muscle in on the product. You can now buy ETFs which go short, which use options and other derivatives much more, which go in for gearing. These are more like actively managed funds or hedge funds. We advise our clients to stay away from them. They are riskier.

I would like them to be called something other than ETFs. Maybe they should be called Professionals’ ETFs or Hedge ETFs or Exchange Traded Active funds. This would highlight the differences and the different risks they are running.

If I worry that markets are going to fall I put my clients into more cash and await the troubles I anticipate. I would never short the market, as that ratchets up the bet. If you are wrong it could very painful. Going short means you can lose very large sums indeed if the market rises against you. If you have merely gone into cash you still have the money with interest, so it’s not a disaster. If you enter complex option strategies you can get those bets wrong and lose substantial sums. You need to be very sure of your view and of the market to make it a profitable activity.

We are in the risk management business. We have a crystal ball, but looking into it requires human judgement which may be fallible. For that reason we say, keep it simple. Buy shares when things look alright for world growth and economic activity. Buy global markets or favoured geographical markets, but buy them through simple ETFs which just seek to track the Index. If you do that you will do better than most active managers.