Exchange Traded Funds (often referred to by the acronym ETF) are a hybrid investment product - part share, part unit trust, part index tracking fund. First introduced in the United States in the early 1990's, they have been introduced to the UK market in the last few years, and are slowly growing in size and popularity.
Whilst ETFs in the United States are more numerous and diverse than those available in the UK, in practise most ETFs launched in the UK are of the index-tracking variety, and track various indices, such as stock market indexes, gold, oil and other commodities.
Essentially, they behave like other index tracking funds. They aim to replicate the performance of an index or indices (such as the FTSE 100) as closely as possible. [In practise, index tracking funds marginally under-perform the index, due to tracking error and the management charges that are deducted from the assets of the fund.]
Like other index-tracking funds, ETFs are eligible investments to be held within Self-Select ISAs and Self-Invested Personal Pension plans (SIPPs).
The promoters of ETFs often refer to the low management charges levied by ETF managers. And it is true that they are low-cost and transparent investment products. The average annual management charge (AMC) is typically in the region of 0.25% - 0.75% (specialist ETFs tend to levy higher charges) and there are no upfront charges (although you will incur stockbroker commissions when you buy and sell ETFs). However, many equivalent Unit Trust / OEIC
Index Tracking funds also have similarly low annual management charges. In fact, the lowest charged index-tracking fund has an AMC of 0.1% with no upfront charges. Therefore, when compared solely on the basis of costs, there is little real difference between ETFs and mainstream index-tracking funds.
However, what makes ETFs different from other index tracking funds is its status as a tradable security. Like other shares, they can be traded in real time via a stockbroker (during normal stock-market opening hours). It is this fact that creates the following subtle differences:
- Shares are priced in real time, and rise and fall during the day. This means that you can precisely time the purchase or sale of shares to your advantage.
- ETFs are effectively open-ended funds, so avoid the discounts and premiums associated with closed-ended investment vehicles such as investment trusts.
- Contrast this to conventional index tracking funds that are only priced on a daily basis. Unless you make a purchase early in the morning, you will usually end up buying units at the next days trading price. Similarly, if you sell units in a conventional Unit Trust or OEIC fund, it may take days to encash your units, and you never know in advance exactly how much the encashment value will be (as the price may rise or fall in that window of time).
[Currently, stamp duty is not charged upon purchases of ETFs, although this status could be reviewed at any time.]
There is another major difference that can be gained from holding ETFs instead of mainstream Index-Tracking funds; namely the ability to use derivative contracts to "hedge" the investment.
Assuming you held a quantity of ETFs, but were concerned that they were going to fall in value over the short term, one option would be to sell the investment and temporarily hold the funds as cash. Another option would be to sell a time-limited "put" warrant against your holdings (this gives the buyer the right to exercise the warrant before the expiry date, and buy your shares at a pre-determined price). If your analysis is wrong, and prices rise instead of falling, the buyer may exercise the warrant and buy your shares at below the then current market value. However, if your analysis is correct, and the market index falls, the warrant is unlikely to be exercised and will expire worthless. Therefore, while the value of your ETF holdings have fallen, you have pocketed the premium for writing the put warrant, and this can be offset against the investment loss.
Such a strategy is definitely not without risks (indeed some people who are risk aware often embark on warrant writing strategies to make additional profits upon their underlying investments). However, the point is that such a course is not open to you if you hold mainstream index-tracking funds - you simply have to accept the fact that they rise and fall in line with their respective index or indices.
Index Tracking Funds and ETFs are becoming more popular as inexpensive core holdings within portfolios; specialist funds and investments bolted around them to provide the additional investment performance. New ETFs are being launched on a regular basis, and are likely to offer more focused investment opportunities over the coming years.