Catch on to this bright investment idea
Whether you want exposure to the blue chip companies listed on the FTSE 100 index or something more exotic such as commodities, nuclear energy or water supply, an exchange traded fund (ETF) is worth considering.
"An ETF is an index-tracking fund that is listed on a regulated market such as the London Stock Exchange," points out Pietro Poletto, head of ETF markets at the London Stock Exchange Group. "Because they are listed in this way, they are bought and sold in exactly the same way as a share."
As well as indices such as the FTSE All Share and the FTSE 100, which are popular among index-tracking unit trusts, ETFs track a variety of different indices. "You can get exposure to a broad range of markets through an ETF," says Tim Cockerill, head of research at Rowan & Co.
"As well as indices from around the world, you can track fixed-interest securities such as corporate and government bonds or the fortunes of commodities such as timber and forestry, sugar and even lean hogs. You can also get more specialist ones that are leveraged or can go short against the market. There's enormous choice."
Furthermore, although ETFs were only introduced in the UK in 2000, they're growing in popularity. Today, there are more than 300 ETFs and exchange-traded commodities (ETCs) listed on the London Stock Exchange and about 2,000 listed around the world.
Investment into ETFs has also grown. According to figures from the London Stock Exchange, while £1.3 billion was traded in 2001, this had increased 26 times to £34.7 billion in 2008.
"ETFs have huge potential for the future,' adds Poletto. "They can be used by everyone from a first-time investor through to a huge institutional investor."
How ETFs work
ETFs track markets in different ways, as Julian Hince, senior business development officer at iShares, explains: "Some ETFs, including our Dublin-domiciled ones, are cash-backed, so the underlying securities are held within the fund. Others, known as swap-based ETFs, are created synthetically through derivatives. Both are common and can result in a low tracking error."
ETFs have advantages over index tracking unit trusts and open ended investment companies (OEICs) as they have the same characteristics as a share. For a start, buying and selling is simpler. While the price for a unit trust or OEIC is set once a day, pricing is real time with an ETF.
Additionally, as you can trade more readily than in unit trusts, you can react to market movements much more quickly. "If your original view on the market turns out to be wrong, it's very easy to change your position. An ETF can be sold immediately and the money reinvested in another more suitable one. This feature can be particularly good in volatile markets," says Poletto.
Cost is another major selling point. "Annual management charges are typically lower than on unit trusts and Oeics," says Graham Spooner, investment adviser at The Share Centre. "A typical charge is 0.4% a year compared with a unit trust management charge of up to 1.75% a year."
Annual charges vary around this average, with some ETFs charging as little as 0.20%. More specialist ones will levy a higher charge, which could be up to 0.75%. Comparing initial charges is more complicated.
On unit trusts you pay a percentage-based charge when you buy, which tends to be around 1% on trackers. For ETFs you pay a share-dealing charge when you buy and again when you sell.
These charges vary but, as an example, The Share Centre charges 1%, subject to a minimum of £7.50, or, if you intend to trade frequently, it has a trader account that charges a flat fee of £7.50 plus a £20 quarterly charge.
While the cost of larger, more frequent trades can be reduced with the trader account, minimum dealing charges can make small trades prohibitively expensive.
While you might need to grapple with dealing charges to find a sharedealing account that suits your trading needs, it's also important to note that, unlike shares, there is no stamp duty to pay on ETFs.
"There was a strong lobby to equalise the ETF trading environment across Europe and this resulted in stamp duty being abolished at the end of 2006," explains Poletto. "This has definitely helped to make ETFs increasingly popular."
Their characteristics mean ETFs are suitable for different investment strategies. Poletto says they can be particularly good for novice investors. "Because your investment is spread across an index or market, ETFs give you access to instant diversification," he explains.
"This helps to reduce risk. If you put all your money in a single stock the risk would be considerably higher."
More experienced investors can also benefit. "ETFs are a good way to get exposure to a market, which might be hard to get exposure to through buying shares," says Spooner. As an example, he points to the Turkish market.
"It's not easy or cheap to get exposure to Turkish companies, but if you bought an ETF that tracks the Turkish stockmarket you have instant, well diversified exposure."
Being able to gain instant exposure to a market also makes ETFs an excellent tool for asset allocation.
Hince likens ETFs to lego. "It's a bit like giving someone a box of lego bricks.They start out with the same set of bricks but can create something completely different to the next person who plays with them," he explains.
For instance, while a first-time investor might look to ETFs to create their entire portfolio, a more experienced investor might use them for their core holdings, spicing them up with other assets.
Cockerill explains:"You could construct a portfolio with 80% invested into ETFs that gives you exposure to the main markets. You could then invest 20% in active funds to give you exposure to different management styles, or in individual shares if you prefer to pick stocks."
Even within the ETF market you can tweak your exposure to an asset. Cockerill explains: "You could invest in a gold ETF if you believed it was going to perform strongly. But if you wanted greater diversification you could go for a precious metals ETF that tracks platinum, palladium and gold."
ETFs are also eligible ISA investments and can be held within a self-invested personal pension (SIPP) wrapper, so can attract the same tax advantages as unit trusts and OEICs.
"Many UK investors have shied away from the stockmarket and bought unit trusts and OEICs through banks and IFAs," says Poletto. "We're trying to change this as ETFs offer many advantages to investors."
This article was originally published in Money Observer - Moneywise's sister publication - in November 2009
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
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.
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
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.
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 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.
Named after a high value gambling chip, the term is used for an investment seen as solid and whose share price is not volatile. Blue chip companies are normally household names and have consistent records of growth, dividend payments, stable management and substantial assets and are the bedrock of a pension fund’s portfolio.