How ETFs could boost your ISA
Combining the benefits of collective investments with the simplicity of shares, exchange traded funds (ETFs) offer an interesting investment option when it comes to your ISA allowance.
While the name makes them sound like a complicated financial instrument used by a day trader, ETFs are very straightforward.
"An ETF is a collective investment scheme, exactly like a unit trust or other fund, that tracks a stated index or asset class. But unlike a fund, it is traded on an exchange like a share," explains Julian Hince, director of ETF issuer iShares.
Because they're a share, just about every ETF is eligible for an ISA. There are exceptions though.
Danny Cox, head of advice at Hargreaves Lansdown, says: "Where they're listed can affect eligibility but so can what it holds, with some of the more complex ETFs not permitted in an ISA.
"Eligibility is determined by the ETF issuer and the ISA provider so, in practice, you shouldn't be able to invest your ISA allowance in one that isn't eligible."
Their simplicity has made them very popular, especially in the US. The bulk of assets under management in ETFs - $700 billion - is in the US, with more than $200 billion in Europe and the remainder in Asia and Latin America.
"ETFs have grown in popularity among UK investors in the last few years and new ones are launching on an almost weekly basis," says Graham Spooner, investment adviser at The Share Centre.
There's plenty of variety in terms of the markets you can access through an ETF. As well as markets such as the FTSE 100, the Cac 40 and the Dow Jones, you can access markets such as Turkey, Korea and Kuwait.
On top of the geographical indices they can track the fortunes of areas such as clean energy or water companies.
Fixed interest and currency ETFs are also available and, with many markets, you also get the option to go short if you think values are going to fall.
As well as ETFs, the exchange traded commodity (ETC), a close relative, gives access to commodities. These can vary in exoticism from oil and gold through to cocoa, soy beans and even lean hogs.
How do they work?
An ETF tracks in one of two ways. Some are cash-based so they track the index by buying all of the constituents of the underlying index and adjusting their weighting in line with the index. Both iShares and HSBC use the cash-based method for their ETFs.
David Chellew, head of market positioning at HSBC Global Asset Management, says this can result in a very low tracking error. He explains: "If someone buys an ETF tracking the FTSE 100, their investment will be used to buy the underlying assets immediately.
"This is much faster than an index-tracking unit trust, as there"s no need to wait for the next pricing point to calculate cash flow and allocate investments."
The other way an ETF tracks is by replicating the performance of an index through a form of derivative called a swap. These are commonly used when gaining exposure to a market is difficult or expensive.
Concerns have been raised about this approach as, unlike the cash-based method where the ETF physically owns the assets and they're ring-fenced for the investors, there is potential risk if the swap issuer, the counterparty, goes bust.
In practice, this isn't possible as the swap issuer provides a basket of securities to provide protection if they fail. "Your investment is protected, but the question is really about transparency. What's in the basket?" says Hince.
"This could affect how quickly you get your money back if something does go wrong."
Why invest in an ETF?
"An ETF gives you access to any market quickly and cheaply," says Spooner. "They also give you fantastic diversification, as you"re potentially buying hundreds of shares through a single transaction."
The way they're traded brings significant advantages. They're easy to access and very liquid. Additionally, because they're listed on stock exchanges, they're priced throughout the day and you pay, or receive, the quoted price.
This differs from unit trusts, which are usually only priced once a day so you don't know how many units you're buying.
Cost is also an important factor, with ETFs being one of the cheapest forms of collective investment. There are no initial charges, other than the dealing costs and the spread between the bid and offer price, and the annual cost of owning an ETF is extremely low.
For instance, while you can expect to pay up to 2% a year for a unit trust, ETFs have total expense ratios of between 0.2% and 0.75%.
When it comes to charges you need to factor dealing costs. Although there's no stamp duty to pay on purchases, ETFs are traded in the same way as shares, so you'll pay a dealing charge when you buy and sell.
Costs vary depending on the share dealing service you use. According to moneysupermarket.com, the cheapest share dealing service is Jarvis's execution-only service X-O, which charges a flat rate of £5.95 per trade.
While this equates to a modest initial charge of just 0.058% if you are going to place your full £10,200 in an ETF, if you only want to buy £100 of ETF shares it's equivalent to an initial charge of 5.95%.
"If you're only going to be investing small amounts you might be better going for an index tracking unit trust.
"There isn't much difference in the annual charge and if you buy through a fund supermarket you won"t necessarily need to pay an initial charge either," says Adrian Lowcock, senior investment adviser at Bestinvest.
ETFS in your portfolio
ETFs lend themselves to a number of investment strategies. Their instant diversification means they're particularly good for first-time investors.
"You could build a portfolio entirely from ETFs if you liked, gaining well diversified exposure to different asset classes as well as markets around the world," says Spooner. But they are more commonly used alongside investments such as unit trusts and shares within a portfolio.
This could be to act as core holdings. You could hold an ETF that tracks the FTSE All-Share index to give general exposure to the UK market, but then buy shares in retail companies as you believe these will deliver the strongest performance, for example.
When considering ETFs Cox says you need to weigh up whether you prefer active or passive management in your portfolio. "ETFs are passively managed investments so performance will only reflect the underlying index.
If you want exposure to a particular market and think an active fund manager won"t be able to add value an ETF is a good, cost-effective option," he says.
Certainly, in some markets active managers are at a disadvantage. "Active management works well in markets such as the UK, Europe and parts of Asia, but isn't so successful in Japan or North America.
In North America, especially in the large cap market, so much company information is available it's hard to add value," Lowcock says.
"We use them in our discretionary portfolios, complementing them with actively managed funds to give our investors the benefits of both approaches."
ETF dos and don'ts
Do understand what you're investing in. "Most ETFs do exactly what they say on the packet," says Graham Spooner, investment adviser at The Share Centre. "But some use leveraging and more risky strategies so check the details before investing."
Do consider them for markets that are difficult or expensive to buy.
Do use them where active managers can't add value, for instance Japan and North American large cap shares.
Don't use ETFs if you only want to invest a small amount. Dealing charges can make them prohibitively expensive.
Don't focus entirely on price - although ETFs are cheap, an active fund manager could outperform the index.
Don't expect them to deliver stellar performance. They track an index so will only perform in line with this.
This article was originally published in Money Observer - Moneywise's sister publication - in March 2010
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
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.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
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.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
A financial instrument where the price is “derived” from a security (share or bond), currency, commodity or index. The price of the derivative will move in direct relationship to the price of the underlying security. They often referred to as futures, options, warrants, interest rate swaps and contracts for difference (CFDs). They are mainly used for financial certainty – to protect against spikes in the prices of commodities – as a hedge, whereby investors can buy a derivative that bets the market will move against them so they protect themselves against potential losses. Derivatives are also a tool of speculation as they enable banks, traders or investors to bet on price movements without having buy the actual physical assets. As derivatives cost only a fraction of the underlying asset price, they are “geared” (leveraged in the USA) so if the price of the asset moves £1, the value of derivative could change by £10.
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 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.
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.