ETFs can diversify risks if invested professionally

Exchange Traded Funds (ETFs) are emerging as an attractive investment option, especially after the onset of the global financial crisis, believe analysts.

ETFs are, basically, traded on a secondary market just like stocks but they track the underlying index. An ETF's main aim is to achieve the same return as a particular benchmark or market index.

Today, ETFs are available in a wide form. They can be denominated in various currencies such as sterling or dollar; could be any country focused such as ETFs on China, India, emerging markets or Latin America; or any sector focused such as oil and gas, agriculture, basic resources or alternative energy. What is more, there are ETFs that are hard or soft commodity focused, equity or bond focused, or gold ETFs, which mainly track the price of gold.

There are also contrarian ETF funds where the objective is to achieve a return from a falling stock market or rising yield on bonds.

"These [contrarian ETF funds] would normally require the ability of going short, ie selling something you don't hold. A process that may not be an option for some investors and ETF could, therefore, be a good alternative if an investor wants hedge against falling markets," says Ole Hansen, Senior Manager for CFD and Listed products, Saxo Bank.

ETFs have become extremely popular over the last couple of years and there are various reasons for that.

ETFs, which since the first launch nearly 20 years ago have seen year-on-year growth at a phenomenal rate, continue to find new followers every day.

The most important feature about ETFs is that it gives investors the access to a wider range of products. By spreading risk during volatile times, they reduce the overall volatility of their investment, says Hansen. "There are advantages [of ETFs] in a well-established market such as the US as there are economies of scale. Because of this, the charges may be lower on ETFs than on mutual funds. Secondly, ETFs are easier to trade and you can buy or sell them in a day. ETFs, thus, are more like a stock that can be bought and sold any time," says Steve Gregory, Managing Partner, Holborn Assets, Dubai.

Kashif Arbab, Managing Director, Killik & Co, Middle East and Asia, Dubai, says: "If you look at ETFs tracking FTSE 100 index, they have given returns of 5.7 per cent in the last three months of 2009. If you look at second half of last year, the return was 28 per cent, while the annual return for 2009 was about 26 per cent.

"Although the return was down three per cent in the past three years, it was up around 30 per cent on FTSE 100 for the past five years until the end of 2009."

According to Arbab, last year, the performance of the Gold ETF – denominated in US dollar which his firm has been buying for its clients since year 2000 – was up 14.9 per cent.

The Gold ETF – denominated in sterling, on the other hand – was up 14.4 per cent in 2009, while the FTSE Gold Mines' performance was 15.4 per cent.

In the GCC, however, ETFs have not taken off at levels as in many parts of the world, analysts say. But experts are optimistic that the asset class will get roots as an prominent investment instrument in the regional capital markets. "I am sure they [ETFs] will become popular in the region because they tend to be cheaper to buy and sell as they're traded normally by stockbrokers," says Gregory.

In the UAE, ETFs are traded on Nasdaq Dubai and Abu Dhabi Securities Market. Elsewhere in the region, they are traded in Qatar and Bahrain.However, a good thing about ETFs being traded here is that they are dollar denominated. That reduces the risk arising out of currency volatility.

"If an investor is earning in dirhams and is investing in dollar-denominated asset class, then the currency risk is greatly reduced as dirham is pegged to the dollar," says Arbab of Killik & Co.

Strings attached

All investment classes are subject to market risks, and ETFs are no exception. "The ETFs track the underlying index and if the market remains volatile, the volatility will be replicated in the ETF. As a result, if the underlying index goes down, the ETF performance will go down as well," says Arbab.

Just because you invested in ETFs, it does not mean that it is going to be less volatile. Volatility of the ETF is derived from the volatility of the underlying benchmark, which it follows. So an investor needs to make sure to get a professional advice before starting to invest in ETFs, he says.

"ETFs are much more volatile than regional mutual funds," according to Gregory of Holborn Assets.

"The disadvantage is that ETFs are not popular with insurance brokers or financial advisors. There is no wide market for these types of funds, which means they are specialist funds and don't have a broader appeal to the public. Additionally, ETFs don't offer easy switching, so you can't switch one ETF for another one free of charge," adds Gregory. The major risks are obviously adverse market moves, says Hansen.

"Comparing to futures, the risk is one for one. That means one dollar invested gives you one dollar market risk. It's not like futures, which operate on a geared basis with one dollar invested giving you a market exposure of $5-$10, depending on which market is traded. An ETF that represents a basket of underlying assets will carry a lower volatility due to its diversified nature," he says.

HOW TO INVEST IN ETFS

Exchange Traded Funds (ETFs) are traded like any other company on a stock exchange and, therefore, easy to access through your local broker or through an online investment bank, says Ole Hansen, Senior Manager for CFD and Listed products, Saxo Bank.

An investor based in this region can have access to ETFs traded in the UK, US or emerging markets or anywhere else and in any currency denomination. But the first thing he needs to do is to approach a professional advisor, say analysts.

An investor has to find a stockbroker or a bank dealing with ETFs and he can give instruction on which ETFs he wants to buy, says Gregory. However, retail investors need to be careful when investing in ETFs, say experts.

"If the investor knows what he or she is buying, then you should go to an execution-only stockbroker or an investment management house who can access the ETFs. Retail investors need to be careful when seeking advice and they should make sure that the company they are approaching is regulated. They should also look at the experience and qualifications of the advisor they are approaching," says Kashif Arbab, Managing Director, Killik & Co, Middle East and Asia, Dubai.

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