Exchange traded funds

Exchange traded funds offer investors cheap, flexible and diverse access to a huge range of global markets. They can be traded just like individual company shares but have a similar risk profile to traditional funds. In the US, net sales of ETFs are expected to reach $61bn this year. The popularity of ETFs has also surged in the UK – the amount of money flowing into them about doubled last year. But awareness of the real benefits of these types of funds remains fairly low among UK investors.

So what are exchange traded funds?
They are quoted securities made up of a basket of stocks that mimic a benchmark rather like an index-tracking fund. But, unlike a tracker, they are bought and sold on an exchange like any other shares rather than directly from a fund manager. They, therefore, provide instant exposure to an entire index through a single security.

What are their benefits?
Exchange traded funds can be traded in real time throughout the day rather than at one fixed point such as unit trusts or mutual funds. This means investors have the flexibility to dash in and out of their chosen index or sector according to movements in the market. ETFs also tend to be cheaper than traditional funds and give diversification as they offer access to whole indices, markets or sectors without the risk of buying just one or two specific stocks, which could underperform. ETFs also provide a good and efficient means of entering more under-researched or illiquid sectors such as emerging markets where it can be difficult to trade in and out of individual stocks.

Another attraction is that you can go “short” on these types of funds – meaning you would benefit from a downward movement in the index or sector. The most accessible way to do this is through contracts for difference – products that allow investors to take a position on the price of an underlying asset such as an ETF without actually acquiring it. You can also put ETFs into individual savings accounts and pensions.

How big is the ETF market?
There are almost 400 ETFs round the world with assets under
management of more than $336bn. The London Stock Exchange said that last year in the UK more than £9bn was traded in ETFs, about double the amount traded in 2004. Most of the increase came at the end of the year following the launch of a series of new funds.

Who offers them?
Barclays Global Investors is the world’s largest provider of ETFs with more than 129 funds listed globally, totalling more than $150bn. It is also the only provider in the UK and its fund brand, iShares, now has 28 ETFs listed in London, of which 14 were listed in October and November. One of the largest issuers in continental Europe is Indexchange, a German group, and there are many providers in the US.

What different types of ETF are there?
The choice of ETFs is already huge and is growing fast. There are funds that track indices from all over the world, including the FTSE 100, S&P 500, MSCI Japan Index, MSCI Korean Index, Dow Jones and Nasdaq. There are also ETFs that track sectors such as oil, gold or telecoms, those that follow only mid- or smaller-cap companies and a recent fund that tracks companies with the most generous dividends.

Who buys them?
ETFs are popular investments for pension funds because of their low charges, and also with institutional investors, hedge fund managers, fund of fund managers and discretionary trusts. Interest from retail investors is also picking up and is expected to grow as awareness increases of the benefits and cost effectiveness of these funds. Some individual investors have also been moving towards ETFs if they have been disappointed with the returns generated by active fund managers. Returns from ETFs typically pretty much match the market, for a fraction of the price of an active fund manager.

How do I get an ETF?
ETFs can be bought and sold easily through a wide variety of
stockbrokers and financial advisers. Experts advise investors to check what ETFs their broker offers as some have access to a wider range than others.

Some independent financial advisers are happy to offer these types of investments to their clients but others have not been as willing to recommend them as they tend not to pay commissions. But as more IFAs migrate towards fee-based structures, they are expected to become more widely recommended by IFAs. One firm specialising in ETFs is iFunds, a UK wealth management group that creates portfolios for its clients that revolve round these funds

What charges can I expect to pay?
ETFs have some of the lowest annual charges of all collective investment schemes. A typical total expense ratio – the total annual drag on performance – of an ETF is between 0.3 per cent and 0.4 per cent compared with about 1.6 per cent for the typical actively managed fund. ETFs are cheaper as they do not need to be actively managed and hence do not need to employ analysts or fund managers. If you buy an ETF you also escape stamp duty charges. Purchases of London-listed shares normally incur stamp duty charges of 0.5 per cent.

What kind of returns can I expect?
The crucial thing to get right, of course, is the asset allocation of the ETF – that is what sectors or markets are going to rise the most. One of the best performing iShares funds in the year to November 2005 was the FTSE 250 fund, which grew by 29.27 per cent.