ETFs - what they are and how to use them

THIS page usually deals with listed exchange-traded products (ETPs) in great depth. Last week, for example, we covered the ins and outs of leveraged exchange-traded funds (ETFs) – which offer all the exposure of an ordinary ETF, except doubled up. But while the UK market for ETFs has expanded dramatically over the last few years, they are still relatively unusual products for most investors to hold. Here we explain what ETFs are and why they matter.

ETFs are mostly quite simple. They are effectively a bundle of stocks, currencies or commodities that trade like shares on the stock exchange. Typically, they track indices, such as the FTSE 100, or the gold price. They can be based on a “physical” portfolio of shares held by the provider, or they can be based on derivative products known as swaps, which replicate an index without being owned by a shareholder.

According to Morningstar, a research firm, the number of ETPs listed on the London Stock Exchange has increased from just four in 2000 to 718 today. 219 new products were listed just last year, including complex leveraged and short ETFs. In terms of assets under management, the total has increased from €100bn in 2008 to €232bn now, mostly through new investment, rather than through asset appreciation.

Jonathan Seal, a director at Rensburg Sheppards in Liverpool, says: “ETFs have been a fantastic development for investors because they offer access to markets at minimum cost, with effectively no initial fee”.

Smaller investors can use them to buy into the FTSE 100, or into more unusual asset classes such as currencies or commodities. And with fund managers in highly developed Western markets only rarely outperforming the market benchmark, the saving of management fees makes them particularly appealing.

“They make it easy to take quick positions – investors can make instantaneous asset allocation decisions cheaply,” Seal says. They are also very convenient vehicles for investors interested in allocating a small part of their portfolio to a particular country – by buying a Polish or Chinese equity ETF for example.

But he also warns that investors need to be well educated about their investments. “With some more esoteric products, there might not be the liquidity in the market”, so ETPs may not always trade at their underlying asset value.

With very common ETFs, like FTSE 100 ones, investors may also find themselves heavily exposed to a particular sector – such as banks before 2008, or mining firms now. “The market seems not to have developed in quite the same way as in the US yet – it’s not that easy to take bets at a sectoral level,” he says. Investors will probably want to use more traditional investments then to build a well-balanced and diversified portfolio. Actively managed funds, for example, might be more expensive than ETFs, and only rarely outperform, but they are also likely to have better risk management.

The typical proportion of a portfolio held in ETPs is still only around 5 per cent. But with ETPs offering ever more ingenious ways for institutional and retail investors to diversify their portfolios, that figure seems only set to rise. One worry, however, is that the products are becoming too complicated. As George King of the Royal Bank of Canada warns, while ETPs have been fantastically innovative and fresh for investors, the increasing complexity of the ETP market “risks killing the golden goose” before it lays all its eggs.

For the moment though, things still seem rosy and the number of interesting products available is expanding. Watch this space to get the latest updates as they emerge.