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.


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