Getting started with Exchange Traded Funds (ETFs)
Exchange-traded funds (ETFs) have been quickly rising in popularity. They are seen as an ultra-low cost way to invest money and gain exposure to a particular market or index.
As with any type of investment, it is essential that you understand ETFs before you start using them. In this article we take a closer look at exchange-traded funds, how they work and what you need to know.
What is an ETF?
In simple terms, an exchange-traded fund is an investment vehicle traded on a stock market. In that sense it is just like a company share. You can buy and sell ETFs on the stock market, just like you might do an individual company share.
Where ETFs offer an advantage over company shares is their ability to give you exposure to an entire index or market sector. Rather than you having to buy (and then trade) an entire basket of company shares which represent a specific index, the ETF does all of the hard work on your behalf.
The goal of an ETF is to generate very similar returns to the underlying index or market sector to which it relates. So, for example, if you buy an S&P 500 ETF, you would expect the returns to vary in line with the performance of the S&P 500 Index. An ETF will never outperform a selected index. In fact, after costs have been deducted it will usually return slightly less, but the returns will be in line with that index.
ETFs have been available in Europe for about a decade now, but since 1993 in the United States where they remain a more popular way for investors to get exposure to different markets.
Index replication
Just like index tracker funds, ETFs aim to replicate the performance of an index. They can do this in a variety of ways, and understanding how these different methods of replication work is important before investing in an ETF.
Some ETFs buy all or a sample of the market they aim to track, and this is known as physical replication. This can take place through full index replication (where the ETF buys all of the underlying securities that form the index) or sampling replication (where the ETF only buys some – a sample – of the underlying securities in the index).
Both methods of physical replication are equally as valid, offering full transparency of the underlying holdings. Sampling replication can result in a higher tracking error, the measure of how closely the fund follows the index. Most importantly, physical replication does not result in ‘counterparty risk’.
Another method of ETF index replication is synthetic replication. This is where the ETF uses financial instruments, typically a swap agreement between an investment bank and the ETF provider. The investment bank (which is the counterparty) essentially agrees to make up the difference between the performance of holdings within the ETF and the performance of the index.
Synthetic replication means precise index replication but it does introduce an additional risk if the counterparty is unable to meet their obligations to make up any performance gap between the securities in the ETF and the performance of the index. This risk can be reduced when an ETF uses multiple counterparties. In absolute terms, the various investment rules associated with ETFs limits this counterparty risk to 10% (or 5% for newer ETFs).
The good
The main advantage of using an ETF within your portfolio is the efficiency they deliver in getting exposure to an index or broad market sector through a single transaction. This clearly lowers the cost and complexity associated with investing a number of individual company shares to try and get the same end result.
Investors favour ETFs because they are quick and simple to trade. As they are listed on stock exchanges, they can be traded (both bought and sold) at any time when the market is open. This means that there should be no real concerns about liquidity. When an investor needs access to cash, they are able to get hold of the same cash value as the value of underlying assets.
Perhaps one of the most appealing attributes of ETFs is the low cost. The average ETF total expense ratio (a measure of the total costs associated with a particular investment fund) is 0.31% per annum in Europe. This compares to an average of 0.87% for the average index tracking fund and 1.75% for the average actively managed fund.
The not so good
After extolling the virtues of ETFs, it would be easy to get carried away and assume they are perfect. Like all things financial, they come with their fair share of disadvantages. These disadvantages might not put off all investors, but you do need to be aware of the pitfalls as well as the favourable attributes before diving in.
ETFs are not typically covered under the terms of the Financial Services Compensation Scheme (FSCS). This protects investors in other funds up to £48,000 per person, made up of 100% of the first £30,000 and 90% of the next £20,000. Whilst ETFs are not covered under this compensation scheme for UK investors, their assets are held as ’segregated liabilities’, which means they remain outside of the control of the ETF promoter.
The cost of ETF investing is low-cost when looking at the total expense ratio, but this ignores other costs you might incur. The annual management charge (AMC) is competitive but in addition to this you might also have buying and selling costs, such as a bid/offer spread and share trading fees.
It still remains the case that ETFs are not all that easy to access. Most investment platforms and pension plans do not offer access to ETFs. In fact, to get access you will probably need to use an online stockbroker or a Self Invested Personal Pension (SIPP) offering access to a very wide range of investment options.
Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice. You can follow him on Twitter @martinbamford.
