By Michael Trudeau
Understand exchange-traded funds (ETFs) and how they can work for you.
What are ETFs?
Tracker funds have traditionally come in the form of unit trusts and Oeics but these are limited in the number of indices that they can track. Exchange-traded funds (ETFs) are a newer innovation in the investment industry..
Like unit trusts and Oeics, they are open-ended, meaning that you can buy or sell in and out of them at any point and their price directly reflects the underlying value of the investments they hold.
The difference is that they are listed on a stock exchange, like shares, and can be traded at any time that the market is open.
Therefore, they can be more transparent, liquid (meaning you can move money in and out of them easily) and flexible than unit trusts and Oeics.
The emergence of ETFs has enabled investors to get access to markets and assets previously unavailable. ETFs can not only track almost any stock market index all over the world, but also the price of commodities, such as gold, oil, natural gas and even lean hogs. These types of ETFs are known as exchange-traded commodities (ETCs).
How do trackers and ETFs track?
There are two primary ways that passive investment funds mimic the performance of an index:
This is the process of buying all components of an index. For example, a FTSE 100 tracker fund will buy shares in all 100 companies in the index, in proportion to size of the companies within the index. This means that funds can mirror the performance of the index as closely as possible.
When it is difficult to buy all the shares in an index, some passive funds invest in a sample of an index that is generally representative of the whole index. A good example of this is the MSCI World index. This comprises more than 1,700 companies from 23 countries - the time and cost it would take to hold all the companies in the index for full replication could be detrimental to the portfolio.
Instead, partially replicated passive funds will purchase a sample of the companies that are most representative of the index itself.
Some ETFs physically invest - they buy the underlying securities in an index and that’s how they will track. Some ETCs buy the underlying commodity, such as gold, and just track the price.
But what about when you want to track a market that’s not as easy to get access to? Or a commodity, such as oil, that’s prohibitively expensive to buy and store? This is where synthetic ETFs come into play.
Instead of buying the underlying shares, bonds, or commodities in an index, the ETF will enter into an agreement with a third party investment bank (a counterparty) to swap the performance of a basket of investments in exchange for the exact return of the stock market or commodity it’s tracking. This is a type of derivative contract.
There are extra risks that come with this. If the third-party investment bank were to fail, some of the investment could be lost. Under regulations, synthetic ETFs are only allowed 10% exposure to a counterparty, meaning that the value of the basket of investments needs to be equivalent of 90% of the value of your investment. Some ETFs now hold over 100% in collateral (full protection against the event of the counterparty failure) to lessen this risk.
It is important to note that many ETFs and ETCs aren’t domiciled in the UK. Therefore, they are not subject to the Financial Services Compensation Scheme (FSCS).
How can you judge passive performance?
ETFs generally have a better tracking error record than tracker unit trust and Oeics, and synthetic ETFs generally improve on this further. But, as we have explained, these options can come with extra risks that you might not be comfortable taking.
How much do ETFs cost?
ETFs typically have ongoing charges of less than 0.5%, with many as low as the cheapest unit trusts.
But not all trackers are cheap - there are one or two with charges as high as 1%. So never assume that a tracker is automatically cheap - it's still important to check the terms of your chosen fund carefully before investing.
- Last updated: February 2016
- Updated by: Michael Trudeau