How to understand exchange traded funds

ETFs are rapidly becoming one of the most popular investment options for both novice and experienced investors. They are among the cheapest types of investment on the market, and they can offer unparalleled diversity by spreading your money across a vast range of stocks and shares. Here’s how they work.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
ETF

Just a few years ago, few people outside the world of finance had heard of an Exchange Traded Fund (ETF). But today, they are everywhere and garner both positive and negative publicity. According to some estimates, the global ETF market is worth more than $4 trillion1, and rose by approximately $1 trillion between April 2016 and April 2017.

During the first six months of 2017, the top-performing ETF had returned 55.78%, outperforming the top-performing mutual fund (Old Mutual UK Smaller Companies Focus Fund R GBP Inc2) by more than 20% over the same period.

So before you start moving your life savings into ETF investing, it’s important to understand exactly what you get with an ETF, and what you don’t.

What are Exchange Traded Funds?

Also known as ‘index funds’, most ETFs invest in a range of stocks and shares within a particular index or sector, with the aim of mirroring (or improving on) the benchmark performance. This is known as ‘passive’ investing, as it does not rely on the expertise of a portfolio manager or fund manager to actively manage each and every change in the portfolio. And since there are no costly managers working away in the background, there are no costly commission fees.

You can also get ETFs that track the price of other assets – commodities or fixed income for example – and you can get wide exposure to geographies and sectors, meaning they’re excellent for building a diversified portfolio. The ETFs themselves are listed on stock exchanges, so anyone can buy shares in them.

The benefits of ETFs

With one ETF investment, you can essentially gain exposure to dozens of different stocks and shares for a flat annual fee. For instance, if you chose an ETF with exposure to the FTSE 100, you could (in theory) be investing in 100 different companies at the same time. As the FTSE 100 changes, so too will your ETF exposure, you are always tracking the top 100 companies in the UK at any given time.

“The great thing about ETFs is that you can genuinely hold one ETF for your entire investment lifecycle,” says Oliver Smith, portfolio manager at IG. 'So, if you want to get exposure to the FTSE 100, traditionally you can either buy the individual stocks, or you could use an active fund manager who may go through periods of underperformance, or who may leave the company while you are still investing in the fund. With an ETF, you genuinely do get the lowest cost exposure to the market that you want. And, of course, you don't have to buy the FTSE 100. There are plenty of other indices that can be tracked.'

Choosing an ETF: what to look for 

Before you invest in an ETF, it is important to understand a couple of key points. 

  • The ETF portfolio effect

ETFs that track the performance of an index, for example, aim to provide similar returns to that index. However, there can be some small differences. For instance, some ETFs only commit to invest up to 80% in their index of choice, with the remainder of the fund being held in cash or invested elsewhere.

Furthermore, due to the fast-moving nature of some indices, the exposure can change over time. If you chose a tech-based ETF in order to gain exposure to Google, for instance, you will need to keep checking the portfolio balance within the ETF over time in case Google is replaced by another firm.

  • Understanding ETF fees

One of the biggest benefits of an ETF is the low fee structure. The vast majority of ETFs will charge annual fees of below one per cent, while many fund managers and stock brokers can charge four times that, plus commission.

However, for novice investors, these fees may still come as a surprise. For instance, if you had invested in the iShares MSCI China (MCHI) at the start of the year, you may be expecting a return of 26.03% by the end of June. In reality, it would be more like 25.39%, after the management fees had been deducted.

“Investors have to remember is that nothing in finance is free,” says Smith. “You've really got to think twice before you run into anything.”

All ETFs come with Factsheets that set out the exposure that the ETF provides in terms of assets and regions, as well as giving details like costs.

Fact sheet 1
Fact sheet 2

While there are risks involved in any investment, overall, ETFs are among the most investor-friendly instruments out there. Do a bit of homework and shop around for your best option (or options) before you commit. And remember, you can always withdraw or change your ETFs at any time.

ETFs can be bought on IG’s share dealing platform, where commissions start at just £5 and there are no custody or platform fees. Use our ETF screener to find the right ETFs for you. You’ll find a downloadable factsheet for each ETF. 

 

1 https://www.forbes.com/sites/greatspeculations/2017/05/17/the-three-largest-players-have-a-70-market-share-in-4-trillion-global-etf-industry/#777359d861f6 
 https://markets.ft.com/data/funds/tearsheet/summary?s=IE00BLP58G83:GBX&mhq5j=e4

 

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