Exchange Traded Funds (ETFs)
ETFs are a relatively new invention. The first one was launched in the US in 1993 and they have only been available to UK investors since 2000. The main ETF providers in the UK include iShares, db-X trackers, ETF Securities, Vanguard and Lyxor.
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 you 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.
Nearly all ETFs are all index-tracking funds and therefore they have much lower charges than most other funds. Many of them have Total Expense Ratios of less than 0.5% a year. In addition, as ETFs are registered outside the UK (typically in Dublin or Luxembourg), you don’t have to pay the usual 0.5% stamp duty when you buy them.
What to look out for
There have been some teething issues with ETFs since they were first introduced.
Smaller funds aren’t always that liquid, meaning they can be difficult to buy and sell. In addition, there have been cases where the price of the ETF hasn’t tracked the index if follows very precisely. This can particularly be a problem with commodity ETFs, which invest in futures contracts rather than the underlying commodities themselves. If you stick to ETFs tracking larger equity markets, none of these issues should really be a problem — but it’s worth being aware of them nonetheless.
If you hold an ETF that is registered outside the UK and you don’t have in an ISA or SIPP, then there can be some complications when it comes to income tax, primarily if you are a higher rate taxpayer. This is due a situation called excess reportable income. It’s beyond the scope of this basic guide, but there is an excellent and very detailed article on the Monevator website that covers it.