Secrets of Success: Funds play markets for all they're worth

My column last week ended by quoting the doubts that Jack Bogle, the founder of Vanguard, had about the concept of exchange-traded funds, one of the new creations that indexing has spawned in the last decade.

Exchange-traded funds (ETFs) are index funds that can be bought and sold throughout the day, as if they were shares.

Unlike conventional unit trusts or Oeics, which are typically priced once a day, the prices of ETFs are updated continuously to reflect the current value of the underlying basket of shares that are in the relevant index.

The mechanics by which this process of continuous pricing is made possible are another example of the wonders of modern technology. But are innovations such as ETFs with us for any significant purpose, or merely here because some clever person wanted to show that such a beast could indeed be created?

My admiration for Mr Bogle knows few bounds, as regular readers will know, but in the case of ETFs it seems to me that he is spitting in the wind. He is, of course, right to say that the idea of a tradeable index fund is something of a contradiction in terms, but there is no doubt that as they have come to be developed - ETFs are meeting different types of professional investors' varying needs.

It may be no accident that Vanguard itself, the great exponent of indexing, quietly junked its previous opposition to the idea of ETFs and introduced its own range a few years ago. This, it has to be said, was precisely because it recognised that the genie was out of the bottle. (Another reason may be that Mr Bogle, who created Vanguard in his own image, and is certainly no blushing violet, has retired and passed on the management to the next generation.)

The reason for his doubts about ETFs is the perfectly sound notion that indexing works best as a long term, buy and hold strategy.

Only by holding for a period of years can investors be sure to reap the full reward of the low costs and low portfolio turnover that lie at the heart of the indexing concept's success. It shouldn't matter to patient long-term investors what day they buy their index funds, let alone whether they buy into their chosen fund at the 11am price rather than the 3pm price.

By definition, if it matters to you that you are able to buy and sell an index fund throughout the day, you are likely to be interested in doing so for trading or speculation purposes. Jack Bogle thinks, quite rightly, that this is not what ordinary investors should be doing with their money.

Short-term stock market trading is a zero sum game, and one that you play at your peril (much better to do it with somebody else's money, as most investment banks do).

But that is not quite the whole story. In most new technologies, the most obvious use is only occasionally the one that turns out to be the "killer application" in real life.

It turns out that ETFs, which are nothing if not a highly flexible investment instrument, have come to be valued for a number of reasons by different groups of investors since they first appeared. It is too simple to say they are merely an instrument for speculation. They also have a useful role to play in other areas, such as asset allocation and risk control.

In fact, it has taken time for ETFs to find their market on this side of the Atlantic since they first arrived from the United States four years ago. In that time, the total amount of money held in the form of equity ETFs has grown from zero to $26bn, according to Morgan Stanley. This is still a tiny fraction of the total funds market in Europe, and about one sixth the size of the ETF market in the United States, which has been going since the mid-1990s.

However, the European market is growing faster than any other this year, and is up around 30 per cent this year so far. Mr Bogle will not be happy about the fact that one of the biggest groups of users of ETFs are hedge funds, who are nothing if not active traders. But hedge funds mostly use ETFs for hedging risk in their portfolios, particularly in less liquid areas of the stock market, such as small and medium capitalisation shares. (Because they are shares, unlike unit trusts, you can go short as well as long of an index.)

Private client investors also find ETFs useful because they are a low-cost way to make adjustments to the overall asset mix of an investment portfolio. Take a typical private client portfolio that has between 40 per cent and 60 per cent in equities and the balance in bonds, property and cash. Using ETFs, these weightings can be adjusted cheaply and instantly with just one or two transactions.

The range of indices is also covered by ETF increases, so it becomes easier to refine the asset allocation process even further. If you want to raise your overall exposure to, say, the Japanese market, then simply buy the relevant ETF. Conventional index funds are a far less flexible way of doing this job and typically cover fewer markets and sectors.

In the same way, if you decide that a big global event, such as 9/11 or an election, has changed the outlook, you can take the necessary action with just one phone call to a broker.

In fact, it is in the area of fine-tuning and managing asset allocation that the real future of ETFs lies. It is true that there is no guarantee that tweaking your portfolio in this way will make you wealthier over time, compared to simply buying and holding a range of conventional index funds. But it is what investors naturally want to do and having a new way of implementing such decisions more cheaply and efficiently than in the past has to be progress.

jd@intelligent-investor.co.uk