ETFs: build a portfolio on the cheap
If you’re thinking of turning to the stockmarket in search of better returns, but are keen to branch out from traditional investment routes, you could consider joining the masses moving into exchange-traded funds (ETFs).
These are far from the preserve of specialist fund managers, with recent months seeing a deluge of interest from people seeking new, low-cost flexible investment opportunities as the financial crisis continues to hit returns.
According to Barclays Stockbrokers, the number of investors piling into ETFs has almost doubled since September 2008. There are now more than 800 of these funds to choose from across Europe, accounting for more than £93 billion of investors’ money. Around £36 billion was poured into the European ETF pot in the past year alone.
What is an ETF?
While ETFs may sound complicated if you’re used to dealing with unit trusts and individual shares, the way they operate is very simple.
They are baskets of shares and can be likened to unit trust tracker funds, in that they mirror a particular index such as the FTSE 100 or the S&P 500. Yet where they differ is that ETFs are traded like shares, providing greater flexibility when it comes to buying and selling.
ETFs are listed on the stock exchange and bought through stockbrokers. They are typically marketed as offering a cheap way of gaining exposure to various stockmarkets, and because they are open-ended, investors do not have the problem of shares trading at discounts or premiums as they do with investment trusts.
While unit trusts are priced daily, shares in ETFs are traded on the stock exchange, so the prices move throughout the day. They therefore offer an efficient way of achieving immediate exposure to an index or sector as it rises and falls in value.
They are also able to track a wide range of asset classes, from commodities to corporate bonds. You can even buy funds that track more esoteric sectors, such as infrastructure or water.
The charging structure for ETFs is basic, as they do not levy front-end charges, early redemption penalties or exit charges, and there is no stamp duty to pay. Service charges are often below 0.5% a year. However, you will have to pay broker-dealing charges, so if you trade a lot it could work out quite expensive.
What's the appeal?
ETFs have recently become very popular. As the financial crisis saw savings rates plummet and actively managed funds failed to beat their benchmark indices, many of us have been searching for more rewarding opportunities.
“One of the main reasons for the rise in popularity of ETFs is their inherent ability to spread risk by investing in selected markets or sectors, and this diversity has become an increasingly attractive prospect to investors in the recent financial storm,” says Nick Raynor, investment adviser at The Share Centre.
“But the attraction doesn’t end there,” he adds. “Because they can be bought and sold throughout the trading day, with prices continually updated like ordinary shares, ETFs provide instant exposure to a portfolio of market indices, sectors and commodities.”
Even so, while overseas investors, particularly in the US, have embraced ETFs as a cheap and flexible way of investing, people in the UK have been more reluctant to join in – they currently only account for around 20% of ETF trades. Yet this is set to change following the recent influx of interest.
One expert, Justin Urquhart-Stewart, director and co-founder of Seven Investment Management, says he could build a balanced and diversified portfolio using only ETFs. “They have great flexibility - and if they are good enough for Warren Buffett [one of the most successful investors in history] they should be enough for you or me.”
If ETFs are so popular, why do advisers not tout their appeal? Well, the answer’s simple; they are not going to benefit from commission. Also, there used to be few ETFs on offer, so they weren’t promoted by advisers – it was uncommon for ordinary investors to consider them.
However, the picture is changing fast, with a vast array of options out there for those who wish to follow this investment route. Gavin Haynes, investment director at Whitchurch Securities, says: “When putting together a portfolio, an adviser should certainly consider ETFs – and these funds are likely to become more widespread following the changes made to the way financial advice is given and paid for in 2012.”
These changes, under the Financial Services Authority's Retail Distribution Review, are aimed at removing commission-bias from the system.
What choice is there?
The first ETF was launched on the Toronto Stock Exchange in 1990, while Barclays Global Investors launched the first European ETF in London in 2000, explains Haynes. “But it’s only recently that they’ve begun to gain momentum in the UK.”
The biggest player in the UK ETF market is iShares, owned by Barclays Global Investors. It covers a wide range of stockmarkets while its fixed-interest offerings include a sterling corporate bond fund ETF, yielding around 6%.
“There are also specialist products that track the likes of clean energy, property, forestry and timber and Sharia-compliant investments,” says Barbara-Ann King, head of investments at Barclays Stockbrokers.
She adds that four emerging markets ETFs accounted for 11% of all ETF purchases in April and May, and these are becoming increasingly popular among investors seeking long-term growth. They include the iShares FTSE Xinhua China 25, iShares, FTSE BRIC ‘50’, iShares MSCI Brazil and iShares MSCI Emerging Markets.
Deutsche Bank is another big provider. It offers more than 30 share-based ETFs on the London Stock Exchange. In addition to the UK’s FTSE 100, FTSE 250 and FTSE All-Share indices, investors can buy ETFs covering stockmarkets such as the US, Brazil, Japan and China. Other ETFs available cover regional indices tracking Europe, Asia, Latin America and emerging markets.
ETF Securities also lists various commodity ETFs on the London Stock Exchange. Investors can select individual ETFs, covering everything from coffee and copper to nickel and natural gas. Alternatively, they can select a basket of commodities, such as grains or precious metals.
So the list of available ETFs is vast. There are also products offering exposure to private equity and global infrastructure, and ETFs that ‘go short’ on some leading indices — which means they aim to make money when the index is falling. You can expect to see a widening array of new products hitting the market in coming months as their popularity increases.
How can investors deal in ETFs?
You can do so in the same way as you would deal in shares, by contacting a stockbroker, usually by phone or via the internet, and placing an order.
Meera Patel, senior investment analyst at IFA Hargreaves Lansdown, says: “Charges between providers vary, but you do have to pay stockbroking charges on top of the annual charge, so you need to be careful of how cost-effective these are if you trade a lot.”
You will pay the broker’s commission, typically a flat fee of between £10 and £50 for an execution-only deal and between 1% and 2% of the deal value for an advisory service. On top of this there will be the annual charge levied by the ETF itself, which varies from about 0.2% to 0.7%. The charges of a typical actively managed fund will tend to be much higher at more than 1.5%.
However, Patel warns: “ETFs will underperform the index they track because charges will eat away at the capital; investors must remember that in a falling market they will track the market down just as much as they can track the market up in a rising market.”
What's the catch?
With an ETF the share price moves in line with the index it is designed to replicate. The price at which you buy or sell will be close to the value of the underlying assets of the share, but will not be exactly the same.
Another downside with ETFs is that the market is relatively immature, and there have been concerns about liquidity. If you want to track the small-cap index, for instance, you may be better off with a unit trust. And if you plan to invest only relatively small sums, the brokerage commission may wipe out the value of your investment, even ETFs are a generally low-cost investment tool.
Also bear in mind that as with any investment product that does not offer protection to capital, the value of investments can fall as well as rise, “so you might get back less than you invested,” says King.
Turning to specific types of ETFs, you may want to be wary of so-called leveraged ETFs. These offer the potential to make extra gains - for example, a 1% rise in an index translating into a 2% rise in the value of the ETF. However, if the markets fall you will lose 2% for every 1% fall.
Patel adds: “It’s also worth considering any counter-party risk – some ETFs will not physically hold the underlying assets and therefore there is a risk that a counter-party could default, which could result in a loss not represented by the underlying index; check this before buying.”
If you want to dabble in ETFs but are a novice, you should opt for funds that track indices such as the S&P500, FTSE100 or MSCI Emerging Market index. Gold ETFs are also useful for investors looking for a safe haven.
Patel says: “Investors new to ETFs should keep it simple – indeed one of the problems with a growing industry is that it gets more and more complicated.”
Are EFTs right for me?
The questions you need to ask yourself:
Q: Are you happy with a passive investment? You will not pay for active management as with conventional unit trusts, but this also means you will not have a manager trying to beat the market.
Q: Are you comfortable putting together your own portfolio of ETFs that will match your risk and return profile? You will not have a manager to do this for you.
Q: Is it cost effective given the amount of money you are looking to invest and your expected frequency of trading? You may find a unit trust or tracker fund is more suitable, depending on your investment style and sum.
Q: Do you already have a pot of accessible savings? If you have yet to build an emergency cash fund, then it’s wise to do this before turning to more complicated investments such as ETFs.
Q: Have you done your research? As these funds are not so widely known and do not have the history of traditional unit trusts, make sure you fully understand what you’re investing in.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
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.
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.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
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.
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.
Describes the relationship between a client and a stockbroker or independent financial adviser whereby the broker or adviser acts solely on the client’s instructions and doesn’t offer any advice on which shares to invest in or financial products to buy and simply “executes” the wishes of the client, regardless if they are judged to be sound or wrong. Other types of broking service offered are advisory (whereby the client/investor makes the final decisions, but the broker offers advice) and discretionary (whereby the broker manages the portfolio entirely and makes all the decisions on behalf of the client).
An acronym, which stands for Brazil, Russia, India and China; countries all deemed to be at a similar stage of advanced economic development. The term was coined in 2001 in a report written by Goldman Sachs director Jim O’Neill who speculated that, by 2050, these four economies would be wealthier than most of the current major G7 economic powers.
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.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.