Learn more about how exchange traded funds, or ETFs, work, and find out whether an exchange traded fund is the right addition to your self select ISA (individual savings account).
Exchange Traded Funds, or ETFs, operate as a sort of cross between unit trusts and investment trusts.
Closed-ended like an investment trust
As far as private investors are concerned, they're closed-ended, like investment trusts. This means that they can avoid most of the administration costs involved with creating and cashing-in units. The flip-side of this is that ETFs are not organised to do this and you will have to find a broker to buy and sell them for you. If you want to invest in ETFs via an Individual Savings Account (ISA), then you'll need to get a 'self-select' ISA from a broker to put them in.
Open-ended like a unit trust
To the big institutions, however, ETFs appear open-ended, like unit trusts. So, if a big bank turns up with a few million in cash, then the managers of the ETF will issue some new ETFs for them. Similarly, if someone turns up with a few million of the ETFs, then the managers will turn them back into cash for them. The effect is that ETFs should trade very close to the value of their underlying assets, without the 'discount' associated with 'closed-ended' funds like investment trusts.
Exchange Traded Funds available in the UK
The ETFs currently available in the UK are known as iShares and they're index trackers. In other words, they track a particular stock market index. In the case of iShares, they aim to do it by fully replicating the shares in a particular index - giving a very small tracking error.
Buying an ETF: does past performance matter?
The most well-known iShare is the 'iFTSE 100' which tracks the FTSE 100 index. There's also the iShares S&P 500, which tracks the S&P 500 index in the United States, plus other funds which follow other major markets and corporate bonds.
Plenty of research has been carried out on whether past performance is a good indicator of future performance. In English this means: should you buy a fund because it has done well in the past? The answer turns out to be no. Which is ironic, really, because evidence shows that most of us do choose our funds on this basis, not least because of the flashy performance statistics that are the main feature of fund adverts. If that wasn't bad enough, the adverts are often rather selective about how they present the data, flattering the true performance of the funds in question. In reality, periods of good performance are often only temporary and will often be followed by periods of poorer performance.
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