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.

What's available?

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, 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

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There was a report a couple of months ago about a UT/OIEC for etfs but i can find no reference to it now.