You may not have heard of exchange traded funds (ETFs). They should let you invest in companies or assets that make up a particular index, but some can be risky. What should you look for?
What are exchange traded funds?
An exchange traded fund (ETF) is an investment fund that you can buy shares in. It’s designed to track a particular index and is a cheaper alternative to ordinary tracker funds.
Exchange traded funds:
- Can be bought and sold on a stock exchange (such as the London stock exchange) as you would ordinary shares.
- Are designed to track a particular index. This can be something like the FTSE 100 (the best known UK stock market index), or the Dow Jones 30.
- Have low charges. Annual management charges can be 0.1-0.5% of the value of your investment, a third or less of the charges on many funds.
- Can hold assets (such as company shares) or ‘replicate’ an index. This is where it can get complicated — and risky. Some ETFs don’t buy shares in companies that make up the index they track, but hold derivatives and other complex instruments that should mimic the behaviour of an index (it’s called ‘synthetic replication’ in the jargon).
Worth investing in or too risky?
ETFs can be a good investment, but they can also be very risky. John Ditchfield from Castleford Investments says that exchange traded funds can reduce costs substantially, especially on money you invest for the very long term, such as pensions. “Many of my clients who invest in ETFs benefit from fund charges as low as 0.30% a year; a big saving when most pension funds cost 1.50% a year or more.”
- The majority of “active” investment funds will fail to outperform against their index over the long-term. The research tends to suggest around 80% of active funds can’t manage to beat their index consistently.
- Individual investors would be wise to stick with physically backed ETFs. These own the underlying asset (shares or bonds and sometime commodities).
- ETFs give you access a wide range of markets at very low cost. These range from big, developed markets such as FTSE 100 and FTSE 250 to international and emerging markets (although these obviously come with greater risk).
Justin Urquhart Stewart of Seven Investment Management has been a fan of exchange traded funds, but is critical of the development of complex ‘non asset backed’ ETFs. “The financial services industry has taken a very simple product — something designed to track an index — and messed it up with complex ‘synthetic’ versions.”
Justin’s tips to reduce the risk of investing in an ETF:
- Make sure the exchange traded fund is tradeable in the UK. Some may be only tradeable in New York or Paris, for example.
- Make sure the ETF is offered by a reputable firm.
- Be careful about the charges and price. The ‘spread’ (the difference between the buying and selling price) will vary.
Should you cash in an ETF?
If you’ve bought exchange traded funds in the past, hopefully you’ll know what they’ve invested your money in. But if you don’t, it’s time to check. Financial advisers recommend the following steps:
- Don’t cash in your exchange traded funds as a knee-jerk reaction. Don’t sell on the basis of a newspaper headline or media report as it could be the worst thing to do.
- Find out what you can about your ETF. Look at the provider’s website or ring their call centre to get some more information.
- Talk to your independent financial adviser (IFA). If you don’t know whether or not to leave your money where it is or what’s in your ETF, ask your IFA. If you don’t have an IFA it may be worth paying someone a fee to review your investments.
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