You are probably familiar with the term ‘Exchange Traded Funds’ (ETFs). But do you really know what it means?
Well, an ETF is an investment vehicle, which is constructed like an open-ended collective investment scheme and trades like an individual security on a stock exchange.
Or, in the simplest of terms, it could be described as a mutual fund/stock hybrid. ETFs provide investors with a variety of benefits over traditional mutual funds including lower expenses.
Consider the following:
One important advantage of ETFs is their low fee structure. ETFs have much lower total expense ratios (TERs) than traditional mutual funds or active funds.
The average TER for fixed income ETFs is 0.19%, and the average TER for equity funds is 0.50%, making them among the cheapest funds on the market.
The average TER for an active fund for example, is 1.71% and for a bond fund 1.03%. An average index fund has a TER of just 0.91%.
In addition, UK investors pay no stamp duty on ETF investments.
A single ETF transaction gives an investor instant exposure to the entire target investment market, helping to spread risk more widely than buying a small basket of individual stocks.
The building block nature of an ETF means that an investor can also achieve diversification by adding a specific market exposure to an existing portfolio.
ETFs are as easy to buy and sell as any large company stock.
Active market making and quick and efficient ETF unit creation/redemption processes provide the depth to handle even the largest of institutional capital flows.
ETFs can have different structures, which will have implications on risk, return and liquidity. It is important that investors examine the differences between them before investing, so that the right fund is chosen for their investment objectives.
Cash-based ETFs are often also referred to as in-specie or physical ETFs, since they hold the underlying securities of the index.
Most cash-based ETFs use full replication of index constituents. In some cases, when it is not considered cost-effective to buy all of the securities in the index (for example when an index is not very liquid), optimisation is used.
This involves buying a portion of the securities within the index and using these to track the index’s performance.
A swap-based ETF uses total return index swaps to replicate an index’s performance. Investors in swap-based ETFs are essentially buying the performance of the index, not the physical securities it contains.
Swap-based ETFs can, in some instances, provide a more tax-efficient investment. They can also be a good way of gaining exposure to markets that cannot be accessed through cash-based funds, such as commodities.
However, swap-based funds are generally considered a slightly riskier investment when compared to their cash-based equivalent, because of their exposure to counterparty risk.
Selecting the right ETF
There are many different considerations when selecting the right ETF for a portfolio. Cost is clearly an important factor, but there are other items to bear in mind, such as:
- Knowing what the ETF owns
- Considering total costs
- Looking inside liquidity
- Assessing the structure
- Evaluating the provider
- Your risk appetite
This is merely a brief introduction to this area of investing. But, in essence, ETFs offer an entirely different way to improve and refine your portfolio.
However, as always, you will either need to do some serious homework yourself or work with someone who is qualified to help you.
Nicholas Watts is an independent financial adviser with Positive Solutions Financial Services which is regulated by the Financial Services Authority. To contact him, use the website www.realwealthmanagers.co.uk