ETFs: build a portfolio on the cheap

7 September 2009

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.”

ETF performance figures are available at private investor websites such as Interactive Investor, our sister magazine Money Observer, and through the London Stock Exchange.

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.

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