This is not the UK small cap index tracker you are looking for

The notorious bankers at Royal Bank of Scotland plugged a big hole recently in the asset allocation choices for passive investors by launching a UK small cap index tracker.1 However my street party was short-lived, as the fluffily-named RBS HGSC Tracker (ticker: RS64) comes with bigger buts than England’s front-row.

Small cap companies have historically trounced the FTSE All-Share2 over the last 50-odd years. Research suggests investors are paid a ‘small cap premium’ for taking a punt on riskier pygmy equities.

Unfortunately the small cap punt is riskier still when it comes in the shape of RBS’s UK small cap index tracker – it’s neither a cuddly index fund nor a comfy old Exchange Traded Fund (ETF).

RBS call it a Redeemable Certificate, and that raises all kinds of questions.

Let’s try to answer a few.

What’s a certificate?

Even though you’re buying the return on a clutch of small cap equities, a certificate doesn’t invest directly in the shares it tracks. It’s effectively debt issued by the bank. In exchange for your money, RBS promises to pay the value of the index tracked, plus dividends.

The debt is unsecured, meaning that if RBS3 goes bust then you’ll probably get buttons. Your investment isn’t backed by a nice cushion of collateral.

That 100% exposure to the credit-worthiness of the certificate issuer is the main drawback of this kind of tracker.

Certificates are an obscure offshoot of covered warrants, are all the rage in Europe, and are the near-identical twins of Exchange Traded Notes (ETNs) that are popular in the US. But I digress.

Other key features of the certificate are:

• The RBS HGSC tracker trades on the London Stock Exchange (LSE).
• You buy and sell it through a broker, just like an ETF.
• The main advantage of a certificate is it does away with tracking error.
• It returns the value of the index minus the annual management fee.
• Dividends aren’t paid out as income but are rolled up into the certificate.

What’s the index?

The RBS UK small cap tracker follows the RBS HGSC (Tradable) TR Index, a cut-down version of the venerable Hoare Govett Smaller Companies index.

• It comprises up to 200 of the smallest 10% of companies listed on the LSE.

• It’s filtered to only include firms that traded an average of £10,000 worth of shares every day over 3 months.

• A company’s weight in the index is capped at 5% to ensure diversity of holdings.

• Weightings are reset once per year.

• TR stands for total return; it means that dividends are assumed to be reinvested in the index.

The FTSE SmallCap index represents the bottom 2% of the UK’s weeniest listed companies. So the full HGSC index (which contains over 400 companies excluding Investment Trusts) would normally bite off a fair chunk of the bottom half of the FTSE 250 as well. Knocking out 50% of the most illiquid tiddlers will heighten that FTSE 250 exposure even more.

But it’s nigh on impossible for retail investors to take a view on that because RBS doesn’t publish details of the index holdings on its website – a miserable failing in comparison to ETF issuers like iShares and db X-trackers.

That alone makes my investing antennae twitch with distress. Understanding the index you’re tracking is a key part of passive investing.

You can at least get an idea of the sector weightings of the full HGSC index courtesy of fund manager Aberforth.

What are the costs?

The annual management charge is 0.6%. Certificates don’t speak in terms of Total Expense Ratio (TER) because they don’t comply to UCITS fund regulations. Again, we’re straying off the garden path and into a darker neck of the woods.

Still, 0.6% AMC is reasonable and compares with:

• 0.85% Aberforth Smaller Companies Trust (Investment Trust)
• 0.58% CS ETF (IE) on MSCI UK Small Cap (ETF)
• 0.27% FTSE 250 Index Retail Acc (Index fund)

On top of that, you’ll pay a spread to buy and sell. The bid-offer spread is 1%, under normal circumstances, according to RBS.

That is steep and is equivalent to paying a load fee for every transaction.

You’ll pay the usual broker’s commission, too.

The HGSC Tracker is supposedly available through all the major brokers. You may need to give them a phone call though because it’s confounding many of the broker search engines I tried, even some of the ‘preferred partners’ RBS lists on its own website.

Try looking in the broker’s covered warrants section if all else fails.

Funny stuff

The certificate has an expiry date. Like most other types of debt it eventually matures and that pay back date is April 19th, 2021.

Come the day, RBS will pay out whatever the index is worth after 10 years, plus dividends. If the index is on its knees then there’s no waiting out the storm, unless you can reinvest in an identical tracker at the time (presumably paying out more on commission and the spread).

You’ll also notice on the HGSC Tracker’s website a number marked ‘effective gearing’. Happily this doesn’t mean you’re exposed to some hideous amount of leverage. It refers to the proportion of the index value that one certificate share represents. If you multiplied the price of one share by the effective gearing ratio then you would get the value of the index.

RBS say you can hold their small cap tracker in an ISA or a SIPP as long as you buy more than five years before its expiry date, but Hargreaves Lansdown, for one, say it’s SIPP only.

While the factsheet cautions you to read the prospectus, RBS have mysteriously failed to put it on their own website – what reason can there possibly be for that in this era of digital communication? Apparently, we’re welcome to pop into their offices to pick up a copy, or it’s available online via the LSE. Good luck finding it. Please tell me if you do.

RBS owns the index the certificate is tracking. That’s a potential conflict of interest brought home when you read this choice piece of small print:

The Index rules may be amended modified or adjusted from time to time by RBS as applicable. Any such amendment may be made without the consent of or notice to investors in instruments linked to the Index and may have an adverse effect on the level of the Index.

Now I’m used to reading things in prospectuses that seem anything from a bit rum to the work of gangsters, but then my usual range of investment vehicles have run for decades without calamity so I might be prepared to give them the benefit of the doubt.

The same can’t be said for certificates. It also turns out that RBS can redeem the certificates early if:

…the closing price of the Index cannot be determined on a particular day due to a suspension or limitation of trading or other disruption to trading or early closure of the London Stock Exchange or any other exchange.

Certifiable?

Taking all this together I can’t say I’m a fan of the RBS HGSC Tracker. Aside from the credit risk (and in truth it seems unlikely that RBS would really be allowed to pop) and the painful bid-offer spread, it’s the lack of transparency that puts me off.

Certificates can be used to provide low-cost access to otherwise hard-to-reach markets, but the only reason you’d choose this particular UK small cap index tracker is because of the sheer lack of alternatives.

Take it steady,

The Accumulator

1. CUKS, the Credit Suisse UK Small Cap ETF is a closet FTSE 250 tracker in my view. [↩]
2. The Hoare Govett Smaller Companies index has outperformed the All-Share by 3.4% per year since 1955 according to a report by Professors Dimson and Marsh, who devised the HGSC index. [↩]
3. That’s RBS the semi-nationalised UK banking behemoth, severely wounded during the credit crunch and saved by the Government. [↩]