What is an ETF, and how can they benefit investors?

An ETF or Exchange Traded Fund is a collective investment scheme – typically formed as an open-ended investment company – that is listed and traded on a recognised stock exchange. The majority of ETFs are passive and aim to track a market benchmark or index. For example, an equity index such as the FTSE 100 or a bond index such as the iBoxx GBP Gilt Index.

ETFs typically offer a well-diversified and low cost means to gain exposure to the returns of a particular asset class, such as UK government bonds or Japanese equities. As they are exchange traded, they can be bought and sold at any time during market trading hours, unlike traditional funds which generally trade once a day.

What are the risks of investing in ETFs?

There are some specific risks to note when investing through an ETF:

• As ETFs are exchange traded, the price can depend on market liquidity. This means that you are not guaranteed to buy or sell at the aggregated net asset value (NAV) of the ETF’s underlying securities. Trading prices above the NAV are known as premiums, and below the NAV, discounts.

• ETFs aim to track an underlying index; however, they will not do this perfectly and some ETFs will be better at tracking the index than others. We refer to the variation in day-to-day performance as the ETF’s tracking error, whereas the difference in performance that can open up over time is known as the tracking difference.

• In order to track the returns of the desired market index, an ETF may purchase the underlying securities that make up this index. This type of ETF is often referred to as physically backed. Alternatively, the ETF manager may enter into a swap agreement with a third party (usually a bank) to exchange the returns from cash invested into the fund for the returns of the underlying market index it is aiming to track. This type of ETF is often referred to as a synthetic ETF.

Why ETFs work well for investment portfolios

We aim to minimise the costs of investing for clients. By making use of ETFs, we can gain market exposure to various asset classes at a low cost. ETFs are, in most cases, passively managed which means that they have low management charges.

ETFs also have the added flexibility of being able to be bought or sold at any time during market hours. It will not always be appropriate to use an ETF to gain exposure to a market and so we will always consider ETFs in the context of all available securities.

Choosing ETFs for our portfolios

Once we have decided that an ETF may be an appropriate way to gain exposure to a market or asset class, we search all available ETFs tracking that market and consider which one to select based on the following criteria:

• The securities which make up the underlying market index of the ETF. For example, both the S&P 500 and the Nasdaq index track US listed companies. However, they do not have the same constituents – the Nasdaq has a greater exposure to technology companies which will mean in some market scenarios the performance of each index will be quite different.

• Total expense ratio of the ETF – this is the total cost of investing in the ETF.

• How well the ETF tracks the underlying market index, which often relies on the manager’s expertise in design, construction and trading.

• Methodology being used to replicate the index – whether a physical or synthetic ETF.

• Size and liquidity of the ETF – some ETFs trade in much larger volumes than others. This will typically mean a lower bid-offer spread, which is the difference in price between buying and selling shares in the ETF.

Do investors pay charges to invest in ETFs?

We don’t charge any transaction fees for buying or selling ETFs or any other investments. However, there are some costs associated with investing in ETFs: the ETF manager will charge a fee for managing the fund and there will be some other costs related to administering the fund.

The total charges for investing in passive ETFs will vary depending on how easy it is to replicate the underlying market index. They can be as low as 0.07% for indices such as the FTSE 100 but may be as high as 0.75% for assets such as emerging market bonds.

These charges will be taken by the ETF manager out of the value of the ETF. We will always take into consideration the cost of investing in an ETF before purchasing it for your portfolio, and highlight the expected total cost of investing to prospective clients. Of course, if you do have any questions, about ETFs or any aspects of our service, please get in touch.

Please note, the value of your investments can go down as well as up.