How Investors Chronicle readers are using ETFs

2014's Portfolio Clinics revealed an appetite for Japanese and emerging markets equity-focused ETFs. Those funds were joined by popular FTSE 100 and 250 trackers, including Vanguard FTSE 100 ETF (VUKE) and iShares FTSE 250 UCITS ETF (MIDD).

However, with 592 new ETPs and 70 individual share class listings debuting last year, decisions about which indices to track and which markets to follow are not easy. In some instances readers were not always choosing the best products for their aims. Here's what we learnt.

 Source: Investors Chronicle, based on Investors Chronicle reader portfolios featured in Portfolio Clinic during 2014

Emerging markets

Three readers featured in 2014 Portfolio Clinic articles were holding the Vanguard FTSE EM ETF (VFEM). These included a 32-year-old investor keen to minimise costs using ETFs holding 14 different trackers and a 69-year-old transferring from stock selection to passive funds.

The fund's key appeal is its straightforward structure and very low price, with a total expense ratio (TER) of 0.25 per cent. Vanguard was the fastest-growing ETF provider in Europe last year behind BlackRock. Its mutual fund structure means it is owned by clients and not shareholders and makes it unique in the asset management industry.

However, the ETF's performance has not closely tracked the FTSE Emerging Markets benchmark over a one-year period. Its share price return was up 9.72 per cent compared to 13.55 per cent for the benchmark index.

Beware of benchmarks

Selection of indices is a major consideration when opting for an emerging markets ETF. For example, the FTSE Emerging Markets and MSCI Emerging Markets indices have fundamental differences when it comes to emerging markets country allocations. Opt for the MSCI Emerging Markets index and South Korea will be included in your portfolio - the country is the second-largest country allocation in the index at 15.57 per cent. However, South Korea does not feature in the FTSE Emerging Markets Index as it is counted as a developed economy.

FTSE's Emerging Markets Index includes exposure to the United Arab Emirates and Pakistan, while MSCI's excludes both countries because it ranks them as frontier markets.

With these differences in mind, investors might prefer iShares Core MSCI Emerging Markets IMI UCITS ETF (EMIM). This product tracks the MSCI Emerging Markets Investable Market Index, which aims to capture 99 per cent of the (publicly available) total market capitalisation. The ETF has 1,777 holdings. It is similarly low in cost with an expense ratio of 0.25 per cent, but tracks the MSCI Emerging Markets Investable Market Index. Its largest holding is China, with a 22.44 per cent weighting, followed by South Korea, to which the fund has a 15.91 per cent exposure.

Choosing countries and companies

It could also be worth taking a punt on riskier emerging markets smaller company ETFs that benefit from low valuations but potentially high growth. One recommendation that we made to investors in the Portfolio Clinic was the SPDR MSCI Emerging Markets Small Cap UCITS ETF (EMSM), which invests in 831 companies.

We also said it could be wise to choose ETFs tracking specific countries rather than betting on the whole region. Manooj Mistry, head of db x-trackers UK at Deutsche Bank, says: "There was a period when individual-country emerging market ETFs tended to move in line with each other, but over the past couple of years we've seen that correlation break down, with markets such as Russia not performing due to geopolitical tensions, in contrast to markets such as India, which have performed well."

Hargreaves Lansdown's head of passive investments, Adam Laird, says: "The biggest choice in emerging markets is whether to buy a broad fund like Vangaurd or iShares or if you want to go down the specialist route and pick areas. A lot of investors will use ETFs to try to cover individual countries and some of those have worked out well."

Turkey is one of those, coming out as one of the top five stock markets last year, and investors could have accessed this market through funds such as db x-trackers MSCI Turkey Index UCITS ETF (XDTK).

Japan and currency hedging

Japan was hugely popular among investors last year due to growing investor confidence in the region and the landslide success of prime minister Abe. We featured the portfolios of five investors who had taken on exposure to the country through products such as iShares MSCI Japan UCITS ETF Acc GBP (CSJP), iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) and Wisdomtree Japan Equity ETF (DXJ).

Investors fared very differently last year depending on whether they opted for hedged or unhedged Japan products, with those opting for currency-hedged products likely to be feeling a lot perkier.

iShares MSCI Japan GBP Hedged UCITS ETF tracks the performance of the MSCI Japan 100% Hedged to GBP Net TR and invests in physical index securities. It also builds in currency hedging using one-month forward FX contracts, to reduce the effect of currency fluctuations between Japanese yen and sterling.

By November 2014 it had already pulled far ahead of the unhedged iShares product, posting a total return of 6.2 per cent over one year compared with 2.8 per cent for iShares MSCI Japan UCITS ETF Acc GBP. However, iShares' unhedged product has effectively tracked the MSCI Japan Index Net index over a one- and three-year period.

There are also costs associated with hedging protection. iShares MSCI Japan GBP hedged UCITS ETF has an ongoing charge of 0.64 per cent compared with 0.48 per cent for iShares MSCI Japan UCITS ETF Acc GBP.

Mr Laird says: "If you believe the yen is going to continue to weaken then it is better to hold a hedged product. In most markets I wouldn't generally consider hedged exposure because the currency adds an element of diversification but Japan has said it wants to weaken the currency and it would be foolish to argue with them too much."

Get on board with Chinese products

Readers might be missing a trick when it comes to the nascent market in Chinese products, with only one reader investing in the region through iShares China Large Cap(FXC). A major development in the ETF market last year came in the form of a proliferation of funds granting exposure to the Shanghai and Shenzhen stock markets after China granted investors new access to its stock market at the end of last year. The Shanghai-Hong Kong Stock Connect programme allows retail investors around the world to invest in mainland Chinese equities for the first time, sending enthusiasm for the region skyrocketing.

Investors can choose between A-shares, trading on the Shanghai and Shenzhen stock exchange or H-shares, listed on the Hong Kong Stock Exchange.

Mr Mistry says: "The Chinese authorities have set limits on the amount of A-shares that can be held by foreign institutional investors through a quota system, but over the past four to five years they've been increasing the quota, which has allowed providers like us to launch ETFs on indices linked to Chinese domestic stocks."

The CSI 300 index tracks the performance of the 300 largest and most liquid A-shares stocks. It has been followed by a series of new ETF launches, including the db X-trackers Harvest CSI300 Index UCITS ETF (RQFI).

However, Mr Mistry says: "With these products people need to understand the benchmark. Ours is tracking the CSI 300, but there is also the FTSE China A50 index, which has a heavy bias towards financials. For investors it's about doing their homework to understand the benchmark they are investing into."

Mr Laird says: "Investors should make the choice between investing indirectly through Hong Kong or directly through Chinese A-shares. A-shares is a more diverse market which covers more sectors and areas. Physical investment is probably preferable. It does carry slightly higher costs, but is a more direct way to invest in a potentially risky market."

Most common ETF mistakes (and how to make the most of ETFs)

One of the most common admonishments coming out of the Portfolio Clinic was the volume of readers with enormous equity portfolios comprising FTSE 100 or 250 stocks and shares but no ETFs.

The lesson here was: if your portfolio is acting like a tracker fund, invest in a tracker fund instead. As a way of gaining relatively cheap access to stock market indices in a more stable way than through pure stock selection, an ETF or tracker fund forms an ideal core to a portfolio.

The US equity market ended December at an all-time high last year, making ETFs linked to the S&P 500 2014's best-selling products. However our in-house economist, Chris Dillow, frequently recommended a FTSE All-Share tracker fund as a way of 'backing the field not the horse' over the long term.

"I think awareness of ETFs is growing and we saw ETF assets rise by 40 per cent last year," says Mr Laird. There are always going to be investors who like to pick individual stocks, but ETFs come into their own because they give investors exposure to areas they wouldn't normally be able to access."