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Guide to Exchange Traded Funds (ETFs)

Expert Financial Solutions Ltd are located in Witney, Oxford, Oxfordshire and offer advice on investment management, advice on wealth creation and advice on wealth management; investment advice for SIPP, ISA or general investment account.

Expert Financial Solutions Ltd are Chartered Financial Planners and independent financial advisers this means that we are therefore able to choose the best investments for you from the entire market place to seek potentially superior investment returns in the medium to long term.

We offer investment advice and wealth management using active or passive strategies or a combination of these two techniques.

Investment advice using an active investment strategy uses actively managed funds and is effectively a search for alpha; put another way, the value added by a professional fund manager.

On the other hand a passive investment strategy seeks consistent beta and tracking error ratio.

Passive investment management will normally use index tracking Exchange Traded Funds (ETFs).

Because Oxford based Expert Financial Solutions Ltd are independent financial advisers we can access all the major ETF providers and we are experienced in researching and using ETFs as part of our investment strategies for clients. Our fund research tools cover the universe of ETFs and although we will normally use the more mainstream index tracking ETFs we can source specific investments for your requirements.

An Exchange Traded Fund or ETF is, in simple terms, a very low cost, diversified investment fund that trades as a single security but gives you investment exposure to an index for example the FTSE All Share Index in which you wish to invest.

ETFs are open ended mutual funds that are different from unit trusts in that they are bought or sold throughout the trading day in the same way as an investment trust or ordinary company share.

Index tracking ETFs can be the core part of a passive investment strategy as the funds returns should be closely related to the index being tracked. Adopting a passive investment strategy is supported by the efficient market hypothesis and is generally lower cost than an active strategy where the total expenses are higher.

An index tracking ETF may have an annual fee of around 0.4% p.a. compared to a typical active managed fund at 1.5% p.a.

ETFs launched in the US in 1993 and subsequently to European markets in 2000. They have grown considerably since then and now there is more than €85 billion across 400 or so ETFs in Europe.

ETFs cover a wide range of investment areas including the main stock market indices such as FTSE 100, FTSE All Share, S&P500, CAC 40 etc as well as bond markets.

More specialist types of ETF may track particular market sectors, or take leveraged or short positions. There are also ETFs known as Exchange Traded Commodities (ETCs) covering such areas as agriculture, precious metals, water, oil, natural gas etc.

The use of an exposure to commodities within an investment portfolio is considered to add to the diversification of the portfolio and ETC are a cost efficient means of accessing exposure to the underlying asset class.

For more information about the use of low cost index tracking ETFs within your SIPP or ISA portfolio please read on or contact Expert Financial Solutions on 0845 2305900 or by email at info@expertfs.co.uk.

Features of ETFs.

Flexibility -- ETFs can be bought and sold throughout the trading day, allowing investors constant access to a live valuation of their investment. The majority of ETFs are eligible to be held within an ISA or SIPP and are a means to achieve a low cost SIPP or ISA portfolio.

Transparency -- the composition of each ETF is usually published daily by the ETF provider allowing investors to analyse their holdings in full.

Low costs -- the total running cost (total expense ratio or TER) of an ETF is generally lower than an index tracker unit trust or OEIC.

Diversity -- ETFs offer direct access to areas in which they would otherwise find it difficult to invest such as energy, livestock, agriculture, precious metals, industrial metals and specific world equity markets.

Stamp Duty -- there is currently no stamp duty payable on the purchase of ETFs.

Low tracking error -- ETFs generally have very low tracking errors.

What are the risks?

General investment risks of ETFs -- as the underlying holdings of an ETF are openly traded securities, they will be vulnerable to market price fluctuations and the value of the investment may rise or fall in value and neither the capital nor any income generated is guaranteed.

Although ETFs normally have a low tracking error and will closely track an index, during times of market volatility, the tracking error of an ETF may increase.

Specific risks of ETFs include ‘counterparty risk’ which relates to the way the in which the ETF tracks the relevant index.

There are two tracking methods in general use by ETF; the first method involves holding some or all of the components of the relevant index; this would be a ‘physical’ ETF. The other method seeks to replicate index performance ‘synthetically’ through an over the counter (OTC) index swap transaction with a counterparty such as an investment bank.

Some ETF will make use of both methods of index tracking and the actual holdings for a specific can be found on the relevant fund fact sheet. A physical ETF with full index replication should have no counterparty risk and full transparency of the underlying holdings and low tracking difference.  

Not all ETF will always physically hold the underlying assets and therefore there can be a risk that the counterparty could default which could result in a loss not represented by the underlying index.

How significant is this risk? Most ETF, or any other mutual fund, that is structured under the Europe wide UCITS III (Undertaking for Collective Investments in Transferable Securities) regulations is subject to diversification requirements and limits on counterparty exposure.

Under UCITS III there are specific limits on counterparty exposure for the synthetic replication type of ETFs such that the maximum exposure to an OTC derivative counterparty is 10% of the Net Asset Value (NAV) of the fund. In practice this means that if the counterparty were to default the fund would be liquidated and investors should get at least 90% of the NAV at the time of liquidation. This does not necessarily mean that an investor would receive back 90% of the amount they had invested since the value at the date of liquidation will depend on the performance of the relevant underlying index.

Counterparty risk on some ETFs is limited to 5% which is below the UCITS III requirements, other ETFs will further mitigate the single counterparty risk by using multiple counterparties, and or may also be collaterised to further increase safeguards for the investor.

Currency risks -- if the underlying investments of the ETF are traded in a different currency to the ETFs denominated currency (i.e. portfolio exposure to dollar but ETF denominated in sterling), there will be additional currency risks to bear in mind.

Volatility -- ETCs are generally higher risk investments, which can experience high price volatility, with the possibility of significant intra day price movements. Although this may not be normal on a daily basis it may be an indication of how volatile the fund may be.

More mainstream, index tracking ETFs, can also experience short term volatility but it is likely to be to a lesser extent than that exhibited by commodity based ETC funds.

Short and or leveraged ETFs are more complicated investments which carry greater risks.
Leveraged ETFs will exaggerate market movements (up and down) and therefore be very volatile with higher levels of risk to capital and also higher potential reward.

Losses with a leveraged ETF can be accumulated at a much quicker rate and there is a greater chance that investors will lose all of their capital.

Because both short and leveraged ETF price movements are calculated using a daily percentage, for periods of more than one day it is possible that they will ''outperform'' or ''underperform'' the relevant index or commodity.

Leveraged ETFs are intended for sophisticated investors who should read the relevant individual leveraged ETF prospectus to ascertain suitability and understand the risks that are involved.

Short ETFs are intended for investors who think the market is going to fall (the ETF price would rise as the market falls; this is called ‘going short’) and may also be used as a small part of a portfolio for investors looking to ‘hedge’ a portfolio against general market falls.

Both short and leveraged ETFs are generally only suited for a small part of an investor’s portfolio, experienced investors with specialist knowledge, and those looking for exposure to a particular type of investment to hold for a specified time period or in certain market conditions. 

Tax treatment of the ETF depends on the tax wrapper (ISA, Pension plan etc) that is used and on the individual circumstances of the investor. The levels and bases of taxation and any tax reliefs may change in future.

Any income payable from an ETF is not guaranteed and may fluctuate.

Please refer to the important information page of our web site.

January 2010.