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Exchange Traded Funds and your portfolio

Published: 3 October 2016

The popularity of exchange traded funds (ETFs) hit a new high in the wake of the EU referendum as investors looked to them as a way of managing market uncertainty.

Trading volumes on London-listed ETFs were 88% higher in June than in the same month the previous year. This was according to BMO Global Asset Management, which reported that the worldwide ETF market also hit a record level that month.

It said demand had risen on the back of market volatility and also reflected increased choice in ETFs.

What are ETFs?

ETFs are perhaps best described as collective funds that are traded on the stock market. Like tracker funds they generally seek to mirror an index or a particular market, such as commodities or currencies. As for all collective investments, the idea is to provide investors with exposure to specific indices, asset classes or sectors without them actually owning the underlying securities.

The products first emerged in the US in the early 1990s, crossing the Atlantic when the first UK-listed ETF launched on the London Stock Exchange in April 2000.

Most ETFs work by replicating indices, either fully or partially.

The traditional approach is to replicate indices entirely, by holding the same investments in the same proportion. This can mean relatively high transaction costs for the fund, as the ETF has to reflect any changes in the benchmark. The partial approach involves holding just some of the holdings in the index while still seeking to mirror its performance, which tends to be used where an index is so big that fully replicating it is likely to be very costly.

Replication can also be synthetic rather than physical. Synthetic ETFs use derivatives (such as swaps) to gain exposure rather than hold the underlying securities. Synthetic ETFs are typically used if the index they are replicating is small (as with specific frontier markets country indices); if it can’t be replicated easily; or if there’s not much liquidity.

Why invest in ETFs?

ETFs are bought and sold like ordinary shares, which generally makes them more liquid (easy to trade) and so means they can give investors access to markets and indices that might otherwise be hard to reach. They also tend to be promoted on the back of their lower charges (in comparison with ‘active’ funds). This has been a key selling point in the low growth environment of recent years, when the impact of fund costs and the transparency of charges have been a subject of debate.

The average ongoing charge for a UK equity income ETF is 0.35%, rising to 0.37% for the average UK-domiciled global equity ETF, according to data from Morningstar. In contrast, the average UK equity income unit trust/OEIC has an ongoing charge of 1.01%, rising to 1.29% for the average UK-domiciled global equity fund

Competition in the market has seen several providers reduce certain charges this year, including iShares (which cut the cost of its FTSE 100 tracker to just 0.07%) and HSBC (which lowered its Euro Stoxx 50 UCITS ETF to 0.05%).

ETFs aren’t subject to Stamp Duty and those listed in the UK are eligible for ISAs and SIPPs. It’s also possible to take income from some ETFs, as they can pay you a dividend linked to the income they get from the underlying holdings.

ETFs do have their downsides, however. As well as the usual investment risks (please read the Important information section at the top of this page to read investment risks), perhaps the most obvious is that they generally simply track indices and so are highly unlikely to outperform them. There’s also the risk of tracking difference, where there’s a discrepancy between the return of the underlying index and that of the ETF (perhaps because of costs incurred).

Using ETFs in your portfolio

The differences between most ETFs (as index replicators) and actively managed funds (where the manager makes asset allocation decisions) mean they can be used in different ways by investors, although many portfolios will contain both types of fund.

As ETFs are generally liquid (easily tradeable) they can be used to manage market uncertainty and take advantage of market movements over the short-term. But the choices available and their low cost mean they can also be used as long-term holdings that act as ‘building blocks’ in a diversified investment portfolio.

We offer over 450 ETFs for you to choose from. You can see the full list here.

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Important information

These articles are designed to help investors make their own investment decisions. They do not constitute a personal recommendation to invest. If you have any doubts as to their suitability you should seek expert advice. Please be aware that the value of investments can fall as well as rise so you could get back less than you invest.

Your existing pension may have valuable benefits which you might lose when you transfer.

Laws and tax rules may change in the future without notice. The information here is our understanding in September 2016.This information takes no account of your personal circumstances which may have an impact on tax treatment.

Past performance is not a guide to future performance.

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