Could ETFs rescue investors from a world of low returns?

Exchange-traded funds are growing in popularity so here are 10 things you need to know about them

Tue, Feb 18, 2014, 01:15

If a fund is domiciled in Ireland (as much of the ETF range from iShares is, for example), the EU, the European Economic Area (which includes Iceland, Liechtenstein and Norway) or an OECD treaty partner it will be taxed under the aforementioned gross roll-up regime. But if the fund is domiciled outside this area, income payments from the ETF are subject to income tax at the marginal rate and disposals are subject to capital gains tax.


Budget changes


Liable as they are to a tax rate of 41 per cent, Westlake argues that products such as ETFs – “or any other investment strategy that is caught by gross roll up for that matter” – may no longer be appropriate for certain groups of Irish investors, including those with low taxable incomes and foreign nationals living in Ireland.

So much so, that Westlake now abides by the following idiom “Don’t let the tax tail wag the investment dog – unless you live in Ireland”.

After all, if you pay income tax at a marginal rate of 20 per cent, why do you want to pay tax on your investments at 41 per cent? As a result, he has been working with clients on finding suitable investments that are liable to income (which could be as low as 27 per cent when universal social charge is factored in) or capital gains tax (33 per cent) rather than Dirt or exit tax (41 per cent). These tax issues makes Westlake “extremely selective about what we buy and how we buy it” when it comes to products such as ETFs.


Risk


Like all market-based investments, ETFs can be risky and there is no guarantee that you will not lose money if the particular fund you choose to invest in slides. And, apart from the risk involved in investing the underlying asset of the ETF, other risks may also apply.

These include counterparty risk, because an ETF does not always hold the physical assets that it tracks. In that regard, it is closer to a derivative than an equity investment. It is always worth while for an investor to check if the ETF owns the underlying assets.

“You would expect the (ETF) manager to buy the individual securities comprising the Iseq or FTSE All-Share index for example. But some ETFs don’t do that and they enter into a swap contract with an investment bank to replicate the index. So risks around counterparties can be an issue,” advises Westlake.

According to Hope Bell, the SPDRs range of funds physically hold the assets in which they are invested, and if this strategy were to change, the fund manager would “give ample notice to investors”.

Another risk associated with investing in passive strategies is that the fund manager is unable to make a defensive move. If a stock in an equity ETF starts to crash, for example, the ETF may lose a lot of its value, and the manager won’t be able to do anything to prevent this. The only way to stop investing in the stock is if it is moved out of the index. Also, while an ETF may be denominated in a particular currency, underlying investments may be held in other currencies. As a result, the investment could be subject to currency risk.

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