Investment masterclass: WTF are ETFs?

This is an audio transcript of the Money Clinic podcast episode: ‘WTF are ETFs?’

Claer Barrett
The world of investments is unhelpfully full of three-letter acronyms. And if you’ve been looking into investing in the past few years, you can’t have missed one that comes up time and time again. I’m talking about ETFs or exchange traded funds. Buying into one has been one of the biggest investment trends of the past decade. But if you’re thinking ETF, WTF, what are they? Then keep listening. Welcome to Money Clinic, the weekly podcast from the Financial Times about personal finance and investing. I’m Claer Barrett, the FT’s consumer editor.

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In this episode, we’re going to be demystifying ETFs. Should you invest in one and how do you go about choosing which ETFs to invest in? And what sorts of charges can you expect? I’m joined by two experts in the studio. Firstly, Lynn Hutchinson, who’s head of ETF and Index Solutions at Charles Stanley. Lovely to have you with us today, Lynn.

Lynn Hutchinson
Claer, nice to be here.

Claer Barrett
And I’m also joined by my colleague Dave Baxter, who is the funds editor at the Investors Chronicle magazine, a sister publication of the FT. Welcome, Dave.

Dave Baxter
Hi Claer. Thanks for having me.

Claer Barrett
Well, first of all, my usual disclaimer on Money Clinic: we are going to be talking about investments and investing. But these are opinions. It’s not intended as individual advice or indeed a recommendation that you should buy or not buy a particular investment. You need to do your own research, as always. But Dave, let’s start with you. Now, for somebody who’s never heard of an ETF and is thinking WTF, well, what are they? What’s your explanation?

Dave Baxter
So basically an ETF is kind of a portfolio or a basket of stocks or different kinds of investments. So you’re putting your money into that and you’re getting exposure to a whole range of different investments focused, normally focused on a sort of established market. So something like the FTSE 100 in the UK or the S&P 500 in the US.

Claer Barrett
Hmm. Now we’re getting into a kind of alphabet soup. ETF. So you’ve got the different indices around the world that you can buy into, but you’ve also got some bits of jargon that really describes how these kind of investments work, whether they pay an income to investors, whether they’re authorised by a particular jurisdiction. We’re going to be covering some of those acronyms later on in the show, but just give people an idea of the kind of brand names that the sort of companies who are making these envelopes or ETFs full of different shares for investors to easily buy.

Dave Baxter
Yep. So you have in terms of the actual indices, the things that the funds will invest in, one of the really big names is MSCI, and they basically compose some of these big, I suppose, lists of stocks to cover a given region. So, for example, they construct the MSCI World Index, which covers lots of kind of different global stocks. And another index composer is Footsie. As I mentioned, you have the FTSE 100, the Footsie All-share, and then you also have S&P. And I suppose another kind of brand to mention is iShares, which BlackRock, which people may have heard of, which is a fund management giant. And it’s worth looking for these kind of established names because there has been a kind of first-mover advantage in the industry and some of the more established names have kind of taken in lots of money. They have really big funds and big funds are, generally speaking, better just because they can be cheapest trades and it kind of reduces your overall cost of investing.

Claer Barrett
OK. Now you’ve just written an article for the Investors Chronicle. People can read it for free online if they register using the link in the show notes today. And you have looked at the top 50 ETFs that you and a panel of experts, including Lynn, have picked that you think investors could use as the basis to form their own research about how they might build their own portfolio using ETFs as the building blocks. And again, I like that analogy, the building blocks. Tell us a bit more about that.

Dave Baxter
So yeah, we think ETFs are really good as kind of the building blocks of your portfolio. They can give you those kind of main exposures. Like I said, you might want US equities or you might want UK exposure and then you can perhaps fiddle on the side and do more specific investments, whether you pick your own shares or whether you buy a so-called active fund where someone kind of tries to pick the best stocks. But in terms of the list, we have basically tried to identify those funds that are kind of cheapest that track the most relevant index and as I mentioned, have things like quite significant size in order to reduce your overall cost of investing. But we, for the last few years, we’ve kind of broken the list into three main categories. So the first one is core. So core ETFs are . . . I’ve mentioned some of those really established markets like the S&P 500. And you know, that can be a really big part of your portfolio. And those are quite simple ETFs. You want to go for big names, you want to go for something that’s very cheap and normally with those ETFs, you shouldn’t expect to pay something more than, say, nought point one per cent in terms of a headline fee. So it should be pretty cheap stuff.

The next category is satellite. So this is more specific kinds of funds. So this might be a fund that deliberately targets dividends. It might be a fund that targets smaller companies. And then we have a very small niche category and which covers commodities. So you want your gold exposure, say you want exposure to oil and also covers. They’ve been, I suppose, quite in vogue in recent years, um, thematic ETFs. So they focus on trends such as the ageing population.

Claer Barrett
I love that one. (laughter)

Dave Baxter
(laughter) Yeah. So that has lots of, for example, healthcare stocks and financial stocks as well. But yeah that’s the structure of the list. So core should generally be your kind of first port of call because those are your main exposures. And then when you want something a bit more interesting, a bit more specific to your needs, you can go for more esoteric ETFs.

Claer Barrett
Brilliant. Now we talk a lot on the Money Clinic podcast about passive investing, investing when you’re tracking an index and using index funds to do that. But how are ETFs different?

Dave Baxter
So it’s basically a structural difference. So ETFs have shares that are traded on the stock markets, whereas what we call index funds will have units and you’re ultimately giving a fund manager money and they’re giving you a unit. But that’s not traded on stock markets. But I would say in terms of the practical difference for an investor, there are probably two things to consider. One is if you’re going for an index fund and you want to buy and sell, that can sometimes take a few days and there is a bit of a wait. Whereas with an ETF because you’re simply trading on the stock market, that can be much quicker. So if you do want to quickly make a decision, if you think the S&P is going to, you know, rise by 20 per cent because X development has happened, then maybe an ETF is quicker, but it can tempt you to trade more, which can incur more costs. And the second important difference relates to charges.

So particularly if you look at the more established platforms, say something like Hargreaves Lansdown, they will levy different platform charges depending on whether you’re holding what they call funds, which in this case would be index funds or if you’re holding shares, which would be ETFs or investment trusts if you’re thinking about active funds.

Claer Barrett
Sure. So you just needs to be really aware of what are the fees that your platform charges and for what.

Dave Baxter
Yeah, yeah. You just have to pay a lot of attention to that. How platforms charge differently and of course, how much they actually are charging.

Claer Barrett
OK. Well, we’ll be delving much deeper into the world of ETFs with Dave and Lynn shortly. But first, let’s hear from Saranya. She got in touch with Money Clinic because she’s keen to know more about investing in ETFs. She’s 38, originally from India, but now lives in Vienna with her husband and young child.

Saranya
I’m an engineer, generally not afraid of mathematics or numbers, but until I think four or five years ago, I basically did nothing with my money other than keep it in my bank account.

Claer Barrett
And when did you start investing? What led you to do that?

Saranya
So I moved to Vienna in 2014, and a year after that, my bank contacted me and said, “You have quite a lot of money in your bank, so can you invest in something?”

Claer Barrett
Now, that prompted Serena to read up about the stock market on FT.com, and she’s now aiming to move the money that she’s built up in her long-term savings into investments. And the way she’s looking to do that is by using ETFs. But as Saranya is finding, there are actually a lot to choose from.

Saranya
Yeah, I want to buy an ETF tracking a certain index, and I find that there are 20 ETFs that do the same thing. How do I find out which one I should pick? Is it the total expense ratio or is it something else that makes one ETF better than the other.

Claer Barrett
And is the cheapest always the best?

Saranya
Oh yeah. I assumed it should be but good to know.

Claer Barrett
Well, Lynn, we’ll be hearing your insider knowledge shortly. But firstly, Dave, let’s stick with you. So if listeners like Saranya have decided that ETFs are the way that they want to build up their portfolio, what kind of things do they need to consider before they start building it up? I mean, the platform that they’re going to use seems an obvious place to start.

Dave Baxter
Yes, so the platform’s very important and you can do research online and kind of the different charges they will have on ETFs and, you know, the kind of level of choice that there is available when it comes to picking ETFs. So that’s a very important first step. And then when you’ve chosen the platform, you would need to set up your accounts. And in the UK, for example, you could start a stocks and shares Isa or you could have a so-called SIPPS — self invested personal pension — if that’s more the kind of area you want to go into. Once you’ve kind of handled those practical elements, you perhaps need to think more about portfolio construction and what the industry calls asset allocation. So that’s basically the exposure you have to different markets, different geographies and to an extent different what they call asset classes, which is things like stocks versus bonds versus commodities.

And yeah, as I kind of as we discussed, you have core ETFs. They’re probably your first port of call because you want to get those kind of exposures to those main markets from the US to Asia to the UK. And once you’ve done that, and that’s the kind of bulk of your portfolio, you can then start thinking about more specific things that you want to do within your portfolio. But speaking of asset allocation, I think it is worth noting that when we talk about these big markets, there are some kind of skews, there are some idiosyncrasies is perhaps a polite way to put it, with the S&P 500, for example, that has done enormously well in the last decade. That’s trounced all the other markets. But there are valid concerns about the fact that it’s so reliant on the Big Tech stocks, you know, things like Apple, Amazon, Microsoft and so on. You know, if you look at, for example, an S&P 500 tracker, then the two biggest constituents recently were kind of Apple and Microsoft, and they made up something like 14, 15 per cent of that fund.

Claer Barrett
So you think you’re buying into a diversified fund with 500 different US shares, but actually two of them account for getting them for a fifth of the exposure. So if Apple’s new virtual reality headset bombs, then, you know, that could have an outsized impact on the performance of that ETF despite the number of funds within the envelope.

Dave Baxter
Yeah. So we held that kind of diversification benefits for ETFs. But you do have to recognise the fact that, you know, it’s not always as diversified as you think. An important point related points is about the kind of global ETFs you might buy. So the MSCI World Index sounds wonderfully international and global, but actually if you had looked recently then it would have something like between I think it’s two-thirds or maybe even approaching 70 per cent in the US markets. And then you look at the US market and as we discussed, that’s so dominated by those few big stocks.

Claer Barrett
OK, Lynn, let’s bring you in here. Now, you described yourself in the podcast greenroom earlier as an ETF geek. But tell us what you get up to in your job.

Lynn Hutchinson
My day-to-day role is selecting ETFs and index funds for our investment managers and community to use in client portfolios or for clients to select to use themselves.

Claer Barrett
So you’ve got a keen nose when it comes to sniffing out ETFs that look good value and those that don’t pass the test.

Lynn Hutchinson
That’s hopefully the case.

Claer Barrett
Well, Saranya has been surprised about the choice of ETFs that’s available out there. And from your perspective, how can investors go about selecting which of these funds to invest in?

Lynn Hutchinson
When looking at ETFs, if you’re a European investor, it’s important to know that for a lot of the US-domiciled ETFs, as a UK retail investor or an individual investor, you can’t actually invest into these US-domiciled ETFs. So they’re ones that you can move out of your selection straightaway.

Claer Barrett
So then if you’re investing from the UK or in Europe, what you want to look out for is another acronym: UCITS that stands for Undertakings for Collective Investment in Transferable Securities. Phew! And Lynn, that basically means . . .?

Lynn Hutchinson
That if you’re an individual investor, particularly in the UK, that they’re eligible for investment into your portfolio. They’re regulated investments.

Claer Barrett
OK.

Lynn Hutchinson
So you can narrow it down then. And then the first thing you need to do is look at the indexes that are being tracked by the ETF.

Claer Barrett
And how could an investor like Saranya look under the bonnet and find out what’s actually in an ETF?

Lynn Hutchinson
Well, the good thing with ETFs is that they’re very transparent. And so the big providers of ETFs, their websites are great and their web pages for each of the ETFs are very good.

Claer Barrett
They have a fun fact sheet.

Lynn Hutchinson
There’s a fun fact sheet, but they also give transparency that you can download a full list of the holdings. You can see exactly how much weight you’ve got in sectors, how much weight you’ve got in individual holdings and in countries.

Claer Barrett
So Saranya said she views ETFs as a safe and easy way of investing without a great deal of knowledge. But Lynn, you’ve got some tips for people who are looking at different ETFs so that they can compare the relative attributes. Now, the first thing that you think investors should look at when comparing similar ETFs are the fees and charges. Now, often another three-letter acronym is used to describe these, which is .

Lynn Hutchinson
An OCF. Or a TER. Some people call it a TER. Some call it an OCF.

Claer Barrett
Decipher for us, please.

Lynn Hutchinson
So, there’s ongoing charges, which is an OCF, and the TER is the total expense ratio. They’re effectively the same thing.

Claer Barrett
OK. And how is this expressed?

Lynn Hutchinson
This is expressed in a percentage. So FTSE 100 ETF can have an OCF or a TER of nought point nought seven per cent.

Claer Barrett
So a very single amount.

Lynn Hutchinson
Yeah. Nought point nought seven per cent on the value of your investment you will pay within the ETF.

Claer Barrett
OK. Now obviously that’s very cheap but then if you’ve got lots of different funds that you’re putting against each other and that’s the column, if you like, that you’re comparing, very easy to see one might be charging nought point nought nine. But your point is don’t always assume that the cheapest is the best. There are other things you should be looking at too.

Lynn Hutchinson
Yeah. And one of the major ones is looking at how the ETF tracks against this index. So effectively the performance. So what, how they should show on the websites where all the factsheets when you look and see what the performance has been is the ETF should track exactly the same as what the index return is, less the OCF. So yeah, if the Footsie ETF returns 1 per cent and the index itself has returned 1.2 per cent, 1.07 per cent, then that’s good because all the difference is the nought point nought seven per cent.

Claer Barrett
But if it’s very different then again that could be .

Lynn Hutchinson
That it’s a warning sign. Yes.

Claer Barrett
OK. Now let’s hear a little bit more from Saranya. Now she lives in Austria, so her income is in euros, but she invested in some dollar-denominated ETFs and found she was getting charged an awful lot for the exchange rate.

Saranya
In every transaction, I lose money because I have to pay this foreign exchange commission. Is it possible at all to avoid this fee?

Claer Barrett
Finally, Saranya had a question around dividends.

Saranya
I’ve noticed that there are two listings for the same index that I wish to track, offered by the same ETF provider. One is dividend paying and another one is accumulating. I don’t know what the difference is.

Claer Barrett
OK, Lynn and Dave, it’s over to you again. Let’s start off with this question of foreign exchange, because obviously Saranya is in Austria, but most of our listeners will be in the UK. Why are so many ETFs listed in dollars and what are the factors that investors have to consider with these extra currency charges?

Lynn Hutchinson
Now, it depends on what platform or bank you’re using to trade. And you know, a lot of platforms will give you the option of whether you want to pay for that trade in euros or sterling or dollars. It’s just restrictions on the platforms or the banks rather than the actual product itself. You look for better banks to pay more interest on your cash. This is similar to that. This is your money. You need to use diligence and make sure you’re getting value for money.

Claer Barrett
So that’s the exchange rate issue dealt with. But Dave, I noticed in your top 50 ETFs list, some of the options were currency-hedged. So UK investors say buying a US fund could try and reduce some of the volatility. Explain how that might work.

Dave Baxter
Yeah, that’s very important. So currency movements can kind of knock your portfolio around a bit, sometimes for better, sometimes for worse. So say you’re a sterling investor holding again an S&P 500 ETF. Then if Sterling strengthened against the dollar, that’s actually a negative because it diminishes the sterling value of that dollar return. So it lessens what you’re getting if you’re, if you’re not hedged.

Claer Barrett
So it’s like when you’re coming back from holiday, you’ve got dollars on the aeroplane and then when you convert them back into pounds when you get home, it’s not as good a deal as when you first went out on holiday. Well, that’s the way I think of it anyway.

Dave Baxter
So personally, and some people would disagree with me, but I always think that it’s actually better to do the slightly boring alternative approach of diversifying by geography, because in theory, over time, those currency fluctuations should simply even themselves out. I suppose if you do have a really strong view and you think Sterling’s going to, you know, rocket or that kind of thing, then that could be an option.

Claer Barrett
Now, let’s talk about charges more broadly. Now, of course, one of the reasons that investors are attracted to ETFs is because the cost of investing is very low. They’re a cheap way of building up a portfolio. But, Dave, there are some fees and charges that investors still nevertheless need to keep a close eye on.

Dave Baxter
Yes, so the main two things are the kind of funds fee and the platforms fee as well, that that can make a big difference to your and returns where you’re getting charged. But there are some other costs, as you know, transaction costs which relate to kind of the costs of trading. You can look for that, but you need to dig around a bit. And that’s why there are things like, for example, our top 50 ETFs list, because we go through the whole kind of market and what’s on offer with a panel of very experienced, you know experts. And you know, we look for things like, as I mentioned, the kind of bigger funds which should offer those economies of scale and should be kind of cheaper to invest in.

Claer Barrett
And finally, let’s move on to this topic of dividends. Saranya has noticed that for lots of the ETFs she’s interested to invest in, there are two different types: one labelled income which pays a dividend and one that’s labelled accumulation. Inc and Acc, to use the three-letter acronyms often flash up on fund websites. Now, Lynn, could you have a go at explaining the difference between Inc and Acc please?

Lynn Hutchinson
Yes, of course. So dividends or as they’re known, income share classes, pay the investor distribution yields which is being received from the underlying equities or bonds on a regular basis. And these are usually paid out to investors on a quarterly or six-monthly basis. Accumulation share classes reinvest the distribution receipt yields received from the underlying equities or bonds back into the ETF or the fund rather than paying out to the investors.

Claer Barrett
OK. So if you wanted to be taking an income from your investments, maybe in retirement . . . 

Lynn Hutchinson
You see income.

Claer Barrett
You would see income so you get money paid out to you every quarter or every six months. But if you’re somebody who’s investing for the long term like Saranya is, then the accumulation would be better because those dividends are being reinvested into buying more stock. So that should help your investment compound over time.

Lynn Hutchinson
Yeah, if you don’t need the income now, won’t get dribs and drabs, then it’s probably best to use the accumulation shares.

Claer Barrett
Fantastic. And finally, Lynn, have you got any other ETF tips for listeners that you’d like to leave us with?

Lynn Hutchinson
My main points would be to make sure, as an investor, to do your due diligence on the ETF or the product that you’ve chose, the index that it’s tracking, but also the platforms as well. Make sure the platform’s the right one for you, that you’re not being charged too much and that it helps the investments that you’re looking to invest in.

Claer Barrett
And what about you, Dave?

Dave Baxter
Well, we do our list kind of every year, and perhaps that is generally a good point at which to review your portfolio. Look at it every 12 months. Look at the ETFs you’re holding. Have you, you know, do you have much more in the US now because it’s performed well? Is it kind of balanced as you want?

Claer Barrett
Need to readjust.

Dave Baxter
Exactly. Yeah. Do you need to sort of recalibrate things?

Claer Barrett
Well, thank you so much there to Lynn Hutchinson from Charles Stanley and David Baxter from the Investors Chronicle.

Lynn Hutchinson
And thanks for having me, Claer.

Dave Baxter
Thank you for having me.

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Claer Barrett
That’s it for Money Clinic with me, Claer Barrett, this week. And we hope you like what you’ve heard. If you did, spread the word, leave us a review. We’re always looking to chat with people about their money issues through the show. So if you’re interested in being part of a future episode and are looking for some expert advice, then email us. Our address: money@ft.com. You could also take a peek at our website FT.com/money. Grab a copy of the FT Weekend newspaper or follow me on Instagram. I’m @ClaerB. Money Clinic was produced in London by Persis Love, Our sound engineer is Breen Turner and our editor is Manuela Saragosa. You heard original tunes this week by famous for Music. And finally our usual disclaimer, The Money Clinic podcast is a general discussion around financial topics and does not constitute an investment recommendation or individual financial advice. For that, you’ll need to find an independent financial adviser. That is the small print for now. See you back here next week. Goodbye.