Exchange-Traded Funds are increasingly popular, but what exactly are they, and how can they work for you?
Exchange-Traded Funds, or ETFs, are increasingly popular because they enable you to gain exposure to a wide range of markets (often stock market indices) at low cost. So here's the lowdown on how they work, and their pros and cons.
ETFs are companies set up to hold a clearly-defined set of assets. Shares in these companies are then sold to investors, and traded on the stock exchange (in contrast to unit trusts, which are sold back to the provider). And unlike investment trusts, whose shares often trade at a discount to the value of their holdings, ETF prices track their holdings very tightly, with any deviation being arbitraged out by the market makers.
Administration of ETFs is very efficient -- the assets are simply bought (either directly, or using derivatives), and the portfolio is re-balanced at fixed intervals according to pre-set rules. There are no customer accounts to manage, and you're not paying a fund manager to have an opinion.
Advantages of ETFs over unit trusts
- Continuous pricing and trading: ETFs are continuously traded during market hours, just like any other share, so you know the price exactly. Unit trust prices, on the other hand, are fixed once per day; trades are transacted at the next pricing point, not the last one, so effectively you're trading blind. If the market was crashing, I'd prefer to have an ETF;
- Very low initial fees: Unit trusts sometimes deduct as much as 6% from your investment as an initial fee -- like a bid-offer spread -- although in the case OEICs and most tracker funds this is replaced by a commission fee. Spreads for the most popular ETFs are less than 0.1%;
- Very low annual fees: ETF's don't charge an annual management fee, but the costs of running the fund are deducted from the total sum invested, thus reducing the return. This deduction, called the Total Expense Ratio, is typically around 0.5% for ETFs thanks to the low administration overhead. Unit trust TERs vary from about 0.5% - 1% for trackers, and can be as much as 5% for some actively managed funds;
- You can sell ETFs short. In other words, bet that the share price will fall;
- Because ETFs are based abroad, mostly in Ireland and Jersey, they don't incur 0.5% stamp duty.
And the disadvantages
- Dividends do not receive tax credits, thanks to their foreign domicile;
- ETFs are traded through your broker, who will charge commission, although some ISA accounts may allow free trading in ETFs. Also remember that you can trade shares for as little as £1.50 using Motley Fool Sharebuilder;
- Normally, dividends are not automatically re-invested.
But the really interesting thing about ETFs is the range of indices and securities they allow you to track. Since their UK launch in 2000, the number of ETFs has grown to more than 80, and more will follow. There's a full list here, but most are provided by two companies:
So whether you just want cheap and convenient exposure to the main markets, or you have strongly-held opinions on the price of pork, ETFs allow you to construct portfolios to suit your needs.
