What are ETFs and why could they be useful for your Isa?

Will Railton
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ETF expense ratios tend to be much lower than those of actively managed funds (Source: Getty)

In today's environment of volatile equities and low bond yields, achieving strong returns is a tall order. So many investors have sought to mitigate the impact of lower returns by cutting out the fees and charges associated with active fund management.

With $3 trillion invested in ETFs, or exchange-traded funds, by the end of last year, they have been luring investment away from conventional managed funds. So what are ETFs and are they good value?

What is an ETF?

Like other funds, ETFs are collective investment vehicles that allow investors to diversify by holding a basket of assets in one place. But there are two major differences. First, while “active” ETFs are beginning to emerge, most ETF funds are designed to passively replicate the performance of a particular index and therefore fees can be much lower. Second, unlike a tracker fund, an ETF is traded like a stock, bought and sold on an exchange.

ETFs have proliferated over the last 20 years, and competition between providers means that you can buy an ETF which tracks the benchmark of almost any segment of any market, from the FTSE 100 and the S&P/TSX Global Gold index to corporate bonds and commercial property.

ETFs can be equal weighted or market-cap weighted. With the former, each constituent company of the index is given an equal weighting in the fund, so your portfolio isn’t dominated by larger companies. Market-cap based ETFs are weighted according to the total share value of each company, so larger firms receive more representation and their performance will have a greater impact on performance.

How else do they differ fom other types of funds?

ETFs are not presided over by a manager who will buy and sell holdings to try to outperform the index. Actively managed funds will attempt to beat their benchmark and skilled managers will do so by picking assets that will outperform.

Unlike mutual funds, which are priced by a fund manager, ETFs are traded on an exchange throughout the trading day. Their prices are dictated by supply and demand so they fluctuate constantly.

What are the advantages of ETFs?

One principal attraction of ETFs is cost. Their expense ratios tend to be much lower than those of actively managed funds, whose manager takes a cut.

ETFs can invest in any type of indexed asset – bonds, stocks, commodities or a basket of different holdings. “They’re very flexible,” says Amanda Rebello, head of ETF distribution for the UK and Ireland at Deutsche Asset Management. “A lot of buy-and-hold investors will use them to construct a straightforward, low-cost portfolio, but they can also be used tactically.” An equity ETF could provide broad exposure to stocks in a large number of emerging markets, she explains, or could be targeted more specifically, with exposure to Indian equities only, for example. “There’s also a large number of bond ETFs in the market now for fixed income exposure.”

By tracking an entire index, investors are not tied to the performance of any single stock and shouldn’t need to trade on a daily basis. And because ETFs are backed by “authorised participants”, which tend to be banks, redemptions can be made at any point.

What are the disadvantages?

Ease of access can be a double-edged sword. There may be a temptation to trade ETFs often, which can result in high fees. And investing regular sums in ETFs may also cost you more in commission than savings in management fees (although some platforms offer commission-free trading).

Furthermore, passive management is better suited to some markets than others. It is very difficult for an active manager to outperform the FTSE 100 and S&P 500, for example, because they are well-researched markets and the component companies are highly likely to be efficiently priced. “All available information on these companies is priced in, making it challenging for analysts and fund managers to unearth attractive investments,” Fidelity Personal Investing’s Daniel Lane has noted.

Emerging markets, meanwhile, are far less-charted territory and passive funds may face trouble. “Gaining exposure to all the companies in an index means that you’re buying all the problems as well as the benefits,” Lane said. So a more expensive active fund may be more suitable in more exotic markets.

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