Five-minute guide to exchange traded funds
Exchange traded funds (ETFs) are being promoted as a low-cost way of investing and have become more popular in recent years. But what are they all about and should you jump on the ETF bandwagon?
What are ETFs?
They are a form of collective investment that can be bought and sold like shares. All ETFs are designed to track an index, which could be anything from the well-known ones, such as the FTSE 100, the FTSE All-Share or an index of corporate bonds, through to more exotic ones, such as the MSCI Brazil, the MSCI South Africa or a timber and forestry index.
You can also buy exchange traded commodities. These share the same characteristics as ETFs but track commodities such as oil, precious metals and cocoa.
I've never heard of them. Are they new?
Relatively. They were introduced to the UK in 2000, although they have been traded for around 20 years in the US and Canada and among institutional investors.
One reason they've kept a low profile is that historically they have not paid commission for independent financial advisers. However following rule changes imposed as part of the Retail Distribution Review, which ban the payment of commission on funds, the playing fields will be levelled and more advisers could start recommending them to clients.
How do they work?
An ETF can track an index in two ways. It can replicate the index, by holding all or some of the underlying shares, or it can create a 'synthetic ETF' using derivatives provided by another company or counterparty.
Whichever method is used, ETFs are very liquid, so you won't have problems buying and selling. On top of this, unlike unit trusts, which are priced once a day, ETFs are priced throughout the day, so you get the price you see rather than the price calculated the following day.
How can I use ETFs as part of my investment strategy?
ETFs are extremely versatile. "ETFs give you quick, low-cost access to a whole market or sector, which makes them ideal as core holdings or where you want to invest in a market that's difficult to access, such as Vietnam or Brazil, for example," says Mick Gilligan, head of research at Killik & Co.
You can also hold ETFs in your individual savings account or self-invested personal pension.
What's the catch?
ETFs are stockmarket investments, so the value can fall as well as rise. This risk can be reduced by holding them for the long term.
You also need to be mindful of counterparty risk if you go for a synthetic ETF, the company issuing the derivatives could go bust and you might lose some of your money.
Although the likelihood of this is slim, it can be a viable concern during volatile periods. Some ETFs are more complex. They might use leveraging and super-short strategies. If these don't perform the way you expect, your loss can be magnified.
What charges are involved?
ETFs are low-cost. There's a small spread between the buying and selling prices and the total expense ratio (TER), which represents the annual running costs, is only meagre.
For example, the iShares FTSE 100 has a TER of just 0.4%. As an added bonus, there's no stamp duty to pay when you buy them.
So how do I invest in them?
ETFs are listed on the London Stock Exchange, so you buy them through a share-dealing service. This means you need to factor in dealing costs, which average out at around £10 a trade.
These can make ETFs expensive if you plan to duck in and out of markets and sectors or want to adopt a monthly investment.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.