MARKET COMMENT
A Cut-Price Way To Invest

By Cliff D'Arcy
March 10, 2004

Here at the Fool, we're big fans of index trackers, because these passively managed funds allow investors access to stock-market returns without paying through the nose.

The overwhelming majority of the capital invested in funds by UK private investors goes into actively managed investments, run by fund managers who select which shares to buy and sell. Naturally, this expertise comes at a cost, in the form of high initial and annual charges.

However, despite taking, say, a fifth of your capital in charges over ten years, around three out of four professional fund managers fail to beat their benchmarks (usually indices such as the FTSE 100 or FTSE All-Share) over the long term.

Because all trackers passively follow the market up and down, the decisive factor for choosing a tracker is its charges – the lower the charges, the better the tracker should perform, all else being equal. Not all trackers are cheap, as this article reveals! The cheapest trackers have no upfront or exit charges, and total expense ratios (which include all costs, both published and hard-to-find) of under 0.75%.

However, there's an even cheaper way to track a chosen index – by buying Exchange Trade Funds, known as ETFs. ETFs are shares listed on a recognised stock exchange, which means that they can be bought and sold in exactly the same way as other shares. Here are the benefits of investing in ETFs:

• Unlike many funds, ETFs have no initial or exit charges.
• When buying ETFs, you do not have to pay stamp duty, which saves you a tax of 0.5% (£5 on every £1,000 invested). This is because the main ETFs are registered in Dublin.
• The bid-offer spread – the difference between the (higher) buying price and the (lower) selling price - is very small for ETFs.
• A typical online broker will charge a commission between £7 and £15 per trade. However, Comdirect offers a scheme called iPlan that doesn't charge investors who buy ETFs (see our Broker centre for more details).
• ETFs can be protected from tax inside an ISA or PEP wrapper.
• EFTs can be traded in real time at any time the stock market is open, whereas unit trusts are only priced once a day, usually based on the previous day's closing prices, which leads to buying and selling delays.
• ETFs are more transparent than unit trusts and other OEICs, because their portfolio holdings can be viewed on a daily basis. Many other funds only reveal their composition twice a year.

One downside to ETFs is that, because they aren't based in the UK, their dividends do not receive tax credits. This means that if you hold them outside of an ISA or PEP, you'll have additional tax to pay, compared to unit and investment trusts.

The ETFs that are available in the UK are known as iShares, and are managed by Barclays Global Investors. One of the most popular is the iFTSE 100 (LSE: ISF) which, no kidding, tracks... the FTSE 100 index! Earlier this morning, these shares were trading at 458.75 to sell and 459 to buy – a spread of 0.055%, which amounts to a mere 55p for every £1,000 invested. This spread is very narrow indeed, even when compared to the most widely traded shares.

The total expense ratio for the iFTSE 100 is 0.4%, which compares favourably with even the cheapest index-tracking unit trusts and OEICs. These charges are lower than almost any other form of investment, partly because ETFs do not pay commission to financial advisers and other middlemen.

So, why pay high management charges for what often turns out to be below-average performance? Whatever your investment approach, your portfolio should benefit from a core holding of ETFs, which give you access to a diversified portfolio at rock-bottom cost!

More: Visit our Online Brokers and ISAs centres | More about ETFs | Choosing The Cheapest Tracker.