Exchange Traded Funds

Having looked at unit trusts, OEICs and investment trusts, now we turn to Exchange Traded Funds or ETFs.

ETFs are a relatively new invention. The first one was lanced in the US in 1993 and they have only been available to UK investors since 2000. The main form of ETFs are offered by Barclays Global Investors and are known as iShares. At the time of writing there were 28 iShares available to UK investors, worth just over £8bn in total.

How They Work

ETFs operate as a sort of cross between unit trusts and investment trusts. 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 continually creating and cashing in units. Like investment trusts, you can buy and sell ETFs via a stockbroker and their prices change continuously throughout the trading day.

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.

If think that all sounds a bit complicated, then you'd be right. However, you don't have to understand this process in any detail to use ETFs and it does have two big advantages for investors. Firstly, it means that ETFs trade very close to the value of their underlying assets, without the 'discount' associated with closed-ended funds like investment trusts. Secondly, it results in ETFs having very small bid-offer spreads, i.e. the difference between the price you can buy and sell them at, making them cheaper to trade than most investment trusts.

Charges

ETFs are all index-tracking funds and therefore they have much lower charges than most other funds. The average Total Expense Ratio for iShares is currently less than 0.5% a year and one fund charges just 0.15%. In addition, as iShares are registered in Dublin, you don't have to pay the usual 0.5% stamp duty when you buy them.

Tax

One complication to watch out for with iShares is that because they are registered in Dublin 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. Therefore unless you're planning to buy and sell your iShares on a fairly regular basis, it makes much more sense to put them in an ISA.

What indices can you track?

The number of iShares is likely to increase in future. At the moment, the most popular funds are the iShares FTSE 100 (LSE: ISF), which tracks the FTSE 100 index, and the iShares DJ Euro Stoxx 50 (LSE: EUE), which tracks 50 leading European shares. Other iShares follow corporate bond indices and the Chinese market. There is an even a iShare that invests in high yield shares, the iShare FTSE UK Dividend Plus (LSE: IUKD).