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."

Investment strategies

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

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