Exchange-traded funds (ETFs) – A quick guide

Exchange-traded funds (ETFs) are one of the pre-eminent investment types today, here is our quick guide to these products. 

ETFs have exploded in popularity in recent years because they are a relatively low-cost way to invest and allow investors to obtain exposure to a market, asset class or sector easily. The fact that ETFs are based on real assets (quantified in their regular Net Asset Valuations) and are traded daily on exchanges also means that they offer a high degree of transparency over performance.

How it works

When an ETF provider launches a new vehicle it asks a third party, which is usually a large financial institution, to buy large quantities of all the stocks underlying the index in question (this party is known as the “Authorised Participant” or AP). The AP would next buy every stock represented in that index and give these stocks to the ETF firm, in exchange for an equally-valued amount of shares in the ETF. This means the provider holds all of the underlying stocks it needs, and the AP can begin trading the ETF shares. You then, as the end-investor, can buy (and sell) shares in the ETF at the stock market as and when you wish.

Benefits

An ETF allows you to gain exposure to – and hopefully enjoy the performance of – an asset without investing directly in it. So, a FTSE 100 ETF allows you to access the investment performance of all the stocks in that index but without owning each individual one (and being hit with all the transaction and management costs that would entail). Or, to give another example, you may be interested in the investment potential of gold but have no desire for the hassle and cost of owning physical bars. In this case your wealth adviser might recommend a gold bullion Exchange-Traded Product.

ETFs can form a very useful part of a balanced investment portfolio, giving you easy access to the investment opportunities which excite you and your wealth manager. Moreover, unlike most actively-managed funds, ETFs are low cost – because they simply track an index and have far less portfolio turnover. In fact, they often carry fees of less than 0.2% per annum.

A further big benefit of ETFs is that most carry lower capital gains levies than actively-managed funds. They also offer flexibility as you can short-sell ETFs, buy on margin, place stop-loss orders and so on. Your investment adviser can take you through the more sophisticated investment strategies if you are interested in ETFs but its also important to understand your own investment approach.

Choosing the right ETF

There are thousands of ETFs to choose from, and they vary according to several criteria. Clearly, the first and most important is the index the ETF tracks, but you should also give thought to its size. Most ETFs hold very significant amounts of assets, but you may be surprised to know that what has long been the world’s largest ETF, the SPDR S&P 500, has over $150bn in assets. Large ETFs are by definition a popular choice for investors. Yet while a large, well-known fund can be reassuring, your investment manager may prefer to suggest smaller, nimbler ETFs for your portfolio. The larger the fund, more inert it and its holdings become (but they are potentially lower risk).

ETFs are intended to mimic the performance of the index they track. However, you should also be aware that many ETFs don’t replicate their underlying index completely (this is referred to as “tracking error” – see our Glossary of Wealth Management Terms for more). They may exclude certain stocks for some reason or hold the index constituents in slightly different proportions: tracking similar assets or sectors does not mean two ETFs are the same at all. Your portfolio manager will be able to go through all these nuances with you as they make investment recommendations.

As a final note of caution, there are lots of ETFs around today which track complex financial products and you should not invest unless you fully understand them. Your wealth manager will help you to understand the risks and returns associated with ETFs.

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