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Part 2 of a new 3-part series designed to provide trustees with a guide to the various types of collective investments they may come across and when and why they might wish to use them.

Like most financial products ETFs were developed as a solution to a number of problems. The problems were:-

1. How does the fund manager of a pension scheme put a £¼Mn in the Brazilian stock market without taking 6 months to find a fund manager, and arrange custodianship and all the rest?

1. How does the same manager put £1Mn in the UK or the US stock market this afternoon without having to get involved with deciding which stocks to buy?

ETFs were the solution and they proved cheap and effective at dealing with tactical and strategic investment problems. As time went on they were also found to be equally effective for private investors, but their structure reflected their institutional roots.

What are they?

ETFs are somewhere between Investment Trusts and Unit Trusts. They are not closed ended funds, but they are not quite as open ended as Unit Trusts. Like an Investment Trust you can only buy ETFs on the stock exchange and prices are set by the market, but if that price varies much from the net asset value, there is a mechanism to limit that variation.

Most ETFs are run by banks and an investment professional can go to the issuer with a defined basket of shares and ask the bank to issue to him a number of units in the ETF in return. Alternatively the investment professional can take EFT units to the issuer and receive shares in return. ETF units are therefore issued and destroyed, but only in wholesale quantities.

In its basic form an ETF is a tracker fund and holds the physical shares matching the index, although the index it tracks can be an Index specifically constructed for that particular ETF. However, some ETFs use alternative methods of tracking the index.

ETFs – swap arrangements

Some ETFs hold shares other than those in the index being tracked and have a swap arrangement with another bank or even the same bank whereby on a monthly or quarterly basis, an adjustment payment is made between the fund and the bank. That way the ETF gets the performance of the target index and the bank gets the performance of the actual physical fund. For example an ETF tracking Scandinavian shares might actually hold German shares but Scandinavian performance is achieved through the swap arrangement. There is therefore some short term counterparty risk if the contracting bank goes into receivership. However, the ETF still has its physical portfolio of shares, all be it different shares from those targeted, which limits the risk. Such a structure may have tax benefits as banks are taxed differently.

At the far end of the scale an ETF may have a bond portfolio and swap that return for an index tracking return.

Tracking commodities

Some ETFs or ETCs try to track commodities and therefore own bonds and deposit those as security against futures contracts. In this case owning physical soya beans or similar is not really an option. These ETFs are continuously selling short dated futures and buying long dated futures. To the extent that there are price differences depending on delivery date, tracking will be imperfect. The price of soft commodities is extremely volatile and is affected by weather and geopolitical events. As investments these are very risky, but the risks are relatively uncorrelated with equities or bonds. For an investor with a relatively large portfolio adding a small investment in a soft commodity ETC is a useful diversifier.

Exchange Traded Notes

Another structure is ETNs or Exchange Traded Notes. These are effectively debt instruments issued by the bank with the returns linked to the performance of a specified asset or assets. As a debt instrument, if the borrower becomes insolvent, then investors have a problem.

Generally ETFs track an Index or at least a specified asset but in principle at least, an actively managed ETF is possible.

Foreign ETFs

The key to profitability for any financial product is volume and the issuer gets that volume by having the same ETF quoted on several stock exchanges across Europe. That means having them set up as an OEIC (Open Ended Investment Company) with a regulatory regime that is acceptable across Europe and has a favourable tax regime. In practice therefore the majority of the ETFs quoted in London are actually Irish OEICs although Luxemburg is also quite popular.

Tax Issues

In order to avoid people using offshore vehicles to defer or even evade tax, HMRC normally charges all gains on offshore collective investments to income tax. In order to be treated the same way as UK collective investments, the funds had to be Distributing under the old Inland Revenue regime, which meant distributing all income to holders and registering the fund with the Inland Revenue.

The new HMRC regime requires the fund to be Reporting which means that it too needs its status to be agreed with HMRC and holders have to have been notified of their reportable income. They then need to report it to the HMRC and pay tax on that reported income. This means that funds can now accumulate income in the same way as UK funds can, but holders have to pay tax on the income, even though they do not actually receive it. Interestingly even when they do receive the income from their units or shares their reportable income may be different from their actual income because of accounting differences.

However, unless there is benefit to having gains subject to income tax, it is probably better that any offshore funds /ETFs have Reporting status. ETFs quoted in London will probably have Reporting status but it is worth checking. ETFs in other European jurisdictions may or may not have Reporting status.

US ETFs will almost certainly not have Reporting status and gains on them will be subject to income tax for a UK holder. They will also be, for UK purposes, unregulated even though they are regulated by the SEC (Securities Exchange Commission) in New York. That is all unfortunate as there is a bigger selection of ETFs available in New York than is available in London. However because of the tax issues they are only really suitable for Pension Funds and Charities. They are not eligible for inclusion in an ISA.

These days many funds which appear to be Unit Trusts actually have the OEIC structure, some of which are domiciled overseas and therefore the Reporting regime is relevant to them as well.