Avoid stockmarket pitfalls with ETFs

The British stockmarket must change if we want it to serve the long-term interests of businesses, investors and the economy. That's the conclusion of an interim review from economist and Financial Times columnist Professor John Kay. The good news is that exchange-traded funds (ETFs) already offer the ideal tool to get around many of the problems he identifies.

Firstly, costs. Kay says that a major long-term goal of his review is to cut the cost of intermediation. Fifty years ago, individuals typically owned shares directly. Now most of us invest via intermediaries, such as pension and mutual funds.

That means the key agents in the investment chain are professional asset managers. But the services of these active' managers have become steadily more expensive, regardless of their underlying performance. That's one reason why ETFs seen as a low-cost alternative to active' funds have grown more popular.

Secondly, Kay wants shareholders to take a long-term view of, and exercise stewardship of, the companies they invest in. One obstacle to this is the fact that active managers are measured against a benchmark index on a quarterly, or even monthly, basis, which hardly encourages long-term thinking.

Company bosses also argue that quarterly financial reporting interferes with planning. Again, this is where individuals investing passively via ETFs have an advantage. There's no need for ETF investors to stick to the most popular benchmarks when choosing a fund. The FTSE 100, S&P 500, MSCI Emerging Markets and Euro Stoxx 50 indices underlie the largest ETFs, but there are many other index options. "Benchmark tyranny" can easily be overcome by going off the beaten track.

Thirdly, Kay asks whether short-term shareholders should be penalised, via the denial of voting rights. Here, ETFs should score better than funds as they tend to have lower internal turnover. But be aware that some ETFs follow indices that are just as high-maintenance as some active funds.

If you're concerned about short-termism and overtrading, check how the index works. Also, check how voting rights are exercised. Your fund manager should have a clear policy on this. Other key questions are: what happens if the index stocks are lent out; and who exercises the voting rights on the index shares in a synthetic ETF structure?

Paul Amery edits www.indexuniverse.eu, the top source of news and analyses on Europe's ETF and index-fund market.