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ETFs: what are they, how to use them, risks, advantages and leverage

ETFs can be used for various strategies such as asset allocation, accessing markets or themes that you cannot easily get from shares, and for hedging

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With ETFs, the financial world is your oyster

Exchange-traded products (ETPs) and exchange-traded funds (ETFs) are a type of investment fund or tracker that provide exposure to certain stock sectors, commodities, bonds or currencies.

Like other passive investments such as index tracker funds, ETPs and ETFs are traded on an exchange like shares, with literally hundreds on offer trading on the London Stock Exchange.

READ: Bringing hedge fund savvy to the investment mainstream

ETFs are designed to passively track the performance of a wide or narrow section of the market, offering a greater diversification than you would get from buying a single share, bond or currency.

By being passive and not employing the decision-making of an active fund manager, an ETF does not offer the possibility of beating the market, but without having to pay for a manager’s services the costs are generally significantly lower.

ETFs are therefore attractive to investors who find the costs of an actively managed fund eat too much into any capital gains they might make — and who believe that beating the market is not necessary.

Today, there are over 1500 ETPs listed on the LSE, the majority of which are ETFs.

In the most recent figures available, UK investors held around £220bn in passive funds at the end of February, up from the £185bn at the start of last year and double the level five years ago, according to the Investment Association.

Wide range of markets and providers

The variety of trackers and ETFs is extremely wide, with brokers and investment supermarkets offering hundreds of options for those who wish to invest this way.

For example, an investor looking to track commodity markets might be able to choose between more than a dozen agriculture ETFs focused on individual crops or livestock types, around two dozen ETFs funds tracking gold or other precious or industrial metals, with funds provided from Invesco, iShares, WisdomTree and Xtrackers.

Moving into the bond markets and equities, there are many dozen to choose from for each region and sector, with ETFs from those same providers plus also the likes of Blackrock, Pimco, State Street and Vanguard.

An investor wanting access to emerging market equities could choose between ETFs that track a certain stock index, such as the MSCI Emerging Markets index, the FTSE Emerging index, the FTSE BRICs index, or could get precise access via a ETFs focused on specific regions or even countries like China, Russia or Brazil.

As well as their online broker’s list of most-popular funds or ‘best buys’, investors can use other online tools, such as Morningstar or TrackInsight, which gather information and compare thousands of ETFs listed in Europe, America and Asia.

Such websites allow you to compare baseline information for each ETF such as ratings, the benchmark, the currency, the market capitalisation, the performance and flows - all for free, with more quality measurements and analytical tools for paid users.

How to compare ETFs

While ETFs generally have lower annual charges than actively managed funds, there can be sizeable differences between ETFs in their level of fee structures. 

For almost all ETFs there will be an ongoing charge or total expense ratio (TER) quoted on your online broker or investment platform, though this may not include all costs of holding the investment. A few basis points might seem inconsequential at first but will add up over the long term. 

Another difference is how ETFs replicate their designated index or market. 

Physical ETFs actually buy and hold the shares or assets of their index, either replicating the index in full or a weighted sample of the main elements.

Buy the constituents of an index in order to deliver the returns of the index is quite straightforward for indices like the FTSE 100 and S&P 500, but can be more difficult for indices that are diversified across multiple countries and where some markets may be difficult and expensive to access.

Clearly, choosing the "right index" is a key first step in the ETF-selection process, as an index obviously defines the investment that the ETF will offer - and sometimes many different ETFs are following the same index and produce a slightly different performance.

Then there are swap-based or ‘synthetic’ ETFs, which use derivatives to track an index with the aim of reducing costs and tracking error. These ETFs hand over a basket of securities as collateral to an investment bank, or counterparty, in return for a swap contract.

ETFs are also different from index tracker funds, which are open-ended investment companies, or unit trusts. These funds are not traded on an exchange, with the price reflecting the underlying value of the assets and calculated only once a day. 

While an ETF will be bought on a bid-offer spread, with a broking fee for buying and selling, a traditional index fund does not normally have a spread but will often carry an initial charge paid to the fund manager.

ETF risks

Among the risks of ETFs, as with other investment funds and individual shares, the myriad options available can lead investors to make unwise decisions.

While the costs are lower for synthetic ETFs, they expose investors to what is known as counterparty risk if the counterparty collapses (for example, Lehman Brothers in 2008), meaning some such ETFs use multiple counter-parties to spread the risk.

As with any investment, there are risks that the investment can go down, so the general advice is that it is better to invest for the long term.

The Financial Conduct Authority has also said that its main concern with ETFs is that “consumers do not always understand that the price of the ETF and net asset value of the underlying fund can diverge significantly”, which the regulator said could clearly result in lower than expected returns. 

While ETPs use complex financial techniques, including borrowing money to increase returns, and so “are not suitable for most people”, the FCA says that ETFs, by far the most popular type of ETP in the UK, “provide greater protection to investors as they as they must comply with EU rules for investment funds”.

Ways of using ETFs

ETFs are useful for adding to diversification in your portfolio, maybe if you invest directly in stocks but are worried about being too strongly weighted towards certain sectors and geographies.

In this case you can use ETFs funds for diversification – to balance your growth prospects or protect against industry or regional risk, such as by accessing themes such as healthcare, cybersecurity, or alternative assets such as gold, platinum. 

By using ETFs, an investor does not require quite the level of stock-picking expertise as direct investing in shares, nor the same level of research into individual companies.

This could be a form of asset allocation for investors who believe asset allocation rather than stock selection is key in driving investment returns, some even use ETFs exclusively to build their portfolio.

However, this does not mean investors should not do any research, as buying an ETF still calls for timing and risk management.

As with equity investing, another strategy pursued by some investors is to ride on the back of a hot sector or theme, such as technology or gold mining, or to take short-term views on countries, commodities and currencies.

This also means ETFs are a good way to get into ESG, one of the themes that built up a head of steam last year, with a number of funds focused on this. This is an example of where some research is needed, as one operator’s definition of what is ESG may differ from another’s.

Investors who follow the business and economic news cycle might want to use ETFs in a cyclical strategy. 

Under such a plan, in the early stages of an economic recovery they would aim to latch onto sectors that traditionally perform well at this time, such financials, before rotating into things like technology and capital goods stocks and then sectors like consumer goods as the upswing takes off, and then into health care and defensives sectors that might be expected to outperform in a downturn.

Slipping into something more sophisticated

ETFs can also be used to hedge broad market- or stock-specific risk, inverse ETPs that provide exposure to broad indices, as well as individual stocks, commodities, and currency pairs, or to implement high conviction views.

Aimed at sophisticated investors and traders, there are also ETFs that alongside the more common long trade, ie expecting a rise, allow you to go short on a specific market, that is you bet on it to fall.

Both normal and inverse ETFs can be leveraged, meaning they provide an accelerated effect of each rise and fall and so should only be used by experienced, sophisticated investors and for short-term bets.

GraniteShares, for example, offers daily ETFs providing long and short exposure to a selection of major companies listed on the London Stock Exchange, including AstraZeneca (LON:AZN), Barclays (LON:BARC), Glencore (LON:GLEN), Lloyds Banking Group (LON:LLOY) and Royal Dutch Shell (LON:RDSB).

Leveraged ETFs can pose hidden dangers that inexperienced investors might not expect, as not only do they have higher than usual costs for the sector but some can also experience higher levels of time ‘decay’ that comes from the multiplier effect of leverage, ie the loss of performance attributed to the multiplying effect on returns of the underlying index of the leveraged ETFs.

This is one reason why leveraged ETFs are not a long-term bet. 

An independent expert

ETFs had kept a low profile historically because, unlike many mutual funds, they have not incentivised financial advisers to promote them by paying a commission for every sale, says Dzmitry Lipski, head of fund research at Interactive Investor.

He notes that key rule changes in 2012, which put all investment products on a level playing field, triggered more advisers to start recommending ETFs.

An important note he makes is that full physical replication for ETFs is harder to achieve, requiring a lot of capital and therefore tend to cost more than those that partially replicate the index, but the performance of ETFs that partially replicate the index could vary over time.

“Synthetic ETFs aren’t the easiest for lay investors to understand as they involve complex financial mechanisms such as derivatives," he says, as well as the abovementioned counterparty risk, though costs are lower.

He highlights that regional ETFs can be especially useful to increase investors' exposure to certain markets like Vietnam or Brazil which are difficult to access outside an ETF.

Myron Jobson, personal finance guru at Interactive Investor, also makes an important point, that ETFs seldom replicate the performance of a given index to a tee because of tracking error, for various reasons.

“Costs, such as legal and auditor fees, which is incorporated in an ETF’s ongoing charge figure, are the main reasons for this divergence. So choosing a lower fee option goes a long way in curbing tracking error.

“However, it is not just fixed costs but variable fees such as bid-ask spread - the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept - that also hack away at performance.

He also points out that the size of the ETF can also have an impact — especially for bond ETFs, as it is difficult to make small investments in bonds — therefore bond funds need to have enough capital to amply track the chosen index.

“Like identical twins, you have to dig a bit deeper to identify core differences that separate one ETF from one provider to another operated by a different provider with the same investment philosophy and approach. Fees are the main reason for a divergence in performance, so it pays to pick the most cost-effective option. But not all ETFs track the given index as successfully as others, so it is important to pick one that has a good track record of doing so," Jobson says.

“Choosing between the two ETFs that track the same index may come down to scrutinising the nitty gritty details.”

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