Launched in a blaze of publicity, Irish-listed ETFs were supposed to be the next big thing. They weren't, writes FIONA REDDAN

DESPITE THE global downturn, exchange-traded funds (ETFs) continue to grow in popularity, with the worldwide market recently surpassing the $1 trillion mark. However, closer to home, Irish-listed ETFs are struggling to make an impression.

Offering investors the ability to track markets at a low cost, ETFs are portfolios of stocks, bonds or other asset classes such as commodities, which are traded on stock exchanges just like the underlying equities. Basically, they allow an investor exposure to a sector – such as mining, banking etc – or an index without having to pick individual stocks.

While the first ETF was listed in Europe in 2000, Irish investors didn’t become overly familiar with the concept until the Irish Stock Exchange (ISE) opened a domestic market in 2005. Launched in a blaze of publicity, Irish-listed ETFs were supposed to be the next big thing for Irish investors.

However, since then, poor market conditions have meant the product has been slow to take off.

The centrepiece of the offering from the ISE was the Iseq 20, which tracked the Irish market.

A major selling point of the product, in addition to the fact it gave exposure to the top 20 stocks on the Irish market – a group that represents 94 per cent of the value of the Irish market – without investors incurring stamp duty, was its low annual management fees, even when compared with a straightforward index tracking fund.

Typically, the average Total Expense Ratio (TER), or management fees, for an equity ETF in Europe is 37 basis points a year (0.37 per cent), versus 87 basis points for the average equity index tracking fund, and 175 basis points for the average active equity fund. The reason for this is the economies of scale that exist in such funds.

As they are designed largely to track indices, they are cheap to run for managers, and usually attract significant assets under management.

When it was launched, in line with European trends, the Iseq 20 promised a very low annual management charge or TER of just 0.5 per cent, which compared very favourably to charges of 1 per cent or above for other similar products on the market.

Unsurprisingly, investors rushed in, and performance in the early days was good, as the last days of the Celtic Tiger pushed the Iseq higher. Now, however, with Irish shares in turmoil, the management charge on the ISEQ 20 has soared, and the product is in stasis.

Some time after its launch, NCB Stockbrokers, promoters of the fund, increased the charge to 0.75 per cent a year, but a collapse in the net asset value of the fund means that these charges are no longer viable. At its height, the fund was worth more than €55 million, but the sharp decline in share values means that its NAV (net asset value) now stands at little more than €20 million.

As a result, the stockbroking firm – which says it had been losing money on the fund and was subsidising it – has imposed a minimum management charge of €250,000 This means that the cost of servicing the fund has risen to 1.6 per cent a year for investors in the fund, in effect leaving them stuck.

If they sell up now to avoid the onerous charge – an investment valued at €10,000 will incur an annual charge of €160 compared to €50 two years ago – they are in effect crystallising any losses they may have made over the past two years.

If, however, they leave their investment as is, they are paying a hefty charge for an investment that will take some time to recover its value.

The one way for the fund to become feasible again is if its value increases, thereby pushing down management charges for investors. But, with share prices remaining volatile, a significant upturn isn’t on the horizon, and new investors may be less likely to invest in an Irish equities fund.

Moreover, even if new investors do choose an Irish equity fund, they are unlikely to invest in one with such a high management charge when cheaper options are so readily available.

Efforts by the ISE to get other Irish-listed ETF products up and running have also been stymied by poor market performance.

For example, in June 2008, the ISE licensed its ISEQ 20 Index to Northern Trust Global Investments (NTGI), the asset management arm of Northern Trust, to create a new Irish ETF for the US market.

By the start of 2009, Northern Trust was out of the business, closing down its line of Northern Exchange Traded Shares (NETS) which consisted of 17 funds, citing “current market conditions, the inability of the funds to attract significant market interest since their inception, their future viability as well as prospects for growth in the funds’ assets in the foreseeable future” as being behind the decision. By the end of 2008, the funds had only attracted €33 million in assets under management.

More successful has been the exchange’s partnership with ETF Securities, a significant player in the global exchange traded commodities market, which began in September 2008.

This move saw the listing of 13 new ETFs, based on a wider range of investment themes including gold, water and alternative energy, on the ISE, and the total invested in these 13 funds is now about €150 million. Moreover, the exchange, continues to look for new opportunities.

“We believe that there is scope for further growth in ETFs as an asset class in Ireland. Options for the further broadening of the ISE’s product offering include additional asset classes such as commodities and fixed income, and we are in ongoing discussions with issuers in relation to doing so,” says Brian Healy, director of traded markets, development and operations with the ISE.

Last summer it launched three new indices which, it was hoped, would lead to the creation of index-based financial products such as exchange traded funds.

The first, the IEX Index, tracks the performance of the 25 Irish-based companies that trade on the Irish Enterprise Exchange, the ISE market for smaller growth companies, while the other two are based on the Iseq 20, and have the same constituents.

The Capped Index limits the maximum weighting of any one company in the index to 9 per cent, thereby providing a greater spread of companies, unlike the Iseq 20, which caps it at 20 per cent.

The Iseq 20 Leveraged Strategy Index assumes an investment equally made up of cash and borrowings, which means that any increase or decrease in the value of the index is magnified for the investor.

Since their launch, however, a spokeswoman for the exchange says that “product origination has been limited” due to market conditions. She adds that, “there is nothing firm in the pipeline at the moment in this regard”.

Nevertheless, Irish investors interested in ETFs shouldn’t be unduly concerned by the failure to date of Irish-listed ETFs to take off in a big way, given that so many other opportunities exist to invest in the product.

“Irish investors need to realise the world is much larger than that, that there is somewhere in the region of 2,000-plus different ETF platforms listed on a global basis,” says Nigel Poynton, director of NCB Wealth Management.

He adds that while investors may have more comfort buying something that is listed on the Irish market, there shouldn’t be any material differences in investing in a product listed elsewhere, although settlement costs might be slightly cheaper when using an Irish broker to buy an Irish ETF.

For all the travails of the Iseq 20, globally ETFs are still very much flavour of the month as investors look to such funds for the access they give to so many different markets, at such a low cost.

Last year, after a decade of rapid growth, assets under management in the vehicles topped $1 trillion for the first time, according to Blackrock.

So just because there is a limited number of ETFs listed on the ISE, it doesn’t mean that Irish investors are prohibited from accessing a much wider variety of funds, as most ETFs can be bought through a stockbroker.

However, investors new to ETFs should consider some key points before allocating their money. For example, given the recent rise in complexity of ETFs, Poynton says he generally recommends that investors stick to the plain vanilla variety.

“Investors need to be conscious of how the mechanism underlying an ETF works,” says Poynton, adding that products that involve leverage, or inverse performance, are very complex and are for more experienced investors.

Investors also need to understand how the fund’s exposure to the relevant index is achieved.

“This can be quite complex, and there could be exposure to credit-based instruments like swaps and futures,” says Poynton, adding, “The safest type of exposure is where the underlying assets are held.”

Another major issue that Irish investors need to be aware of is the tax treatment of ETFs. Although they are traded like a share, ETFs aren’t taxed like one, which means that investors must pay exit tax at 28 per cent on any gains and tax on income from dividends at 25 per cent, and aren’t able to carry forward a loss as can be done under capital gains tax. Moreover, investors also need to file an annual tax return to declare their interest in ETFs.

Another issue is the dividend withholding tax, which is applied in different jurisdictions, and which, says Poynton, can be difficult to reclaim. He recommends investors first consider Irish domiciled funds, due to the tax difficulties arising when ETFs are domiciled in different jurisdictions. “An Irish domiciled fund is easier for an Irish investor,” he advises.

Luckily, one advantage for Irish investors in the development of Dublin as a leading global funds servicing centre is that so many ETFs are actually domiciled in Ireland.

Many on Blackrock’s iShares platform, for example, which is responsible for managing about half of the global ETF market, are domiciled here. Poynton advises that investors check the fund prospectus before making a decision.

ETFs: Tax treatment

• Exchange Traded Funds (ETFs) may be listed on the Irish Stock Exchange like a normal share but they are not. They have their own rule son tax liabilityExit Tax: In tax terms, ETFs are more like a unit fund than a share. Investors will have to pay exit tax at 28 per cent on any gains when the capital is withdrawn from the fund.
• Dividends: dividends paid by an ETF are subject to tax at the rate of 25 per cent.
• Capital Gains Tax: The capital gains tax regime does not apply to ETFs. Most importantly, especially in current circumstances, investors cannot carry forward losses in the same way they would with normal equities.
• Dividend Withholding Tax: Applies differently, depending on the jurisdiction in which the fund is domiciled. It can be difficult to reclaim. Investors should check funds' domicile which, for many, is Dublin.
• Tax Returns: Investors in an Exchange Traded Fund are obliged to file an annual tax return declaring their interest in the ETF.