What is a ETF?

Like traditional tracker funds, Exchange Traded Funds (ETFs) aim to mimic the performance of a particular market or index such as the FTSE 100 and like a traditional tracker their value is determined by whether or not the index rises or falls.

But ETFs differ in that they are traded like individual stocks, on an exchange such as the London Stock Exchange and can be bought and sold through brokers in the same way as any other listed stock.

ETFS are passive investments in that they are not actively managed by a fund manager who chooses which assets to buy and sell. An ETF has holdings in every company on the index and only buys and sells holdings to reflect movements in the market.

One of the main attractions of ETFs over traditional trackers or active funds is that they are priced continuously throughout the day, whereas conventional funds are priced just once a day and you do not know what the price will be before you buy or sell.

ETFs are therefore ideal for investors who want to profit from short-term movements. You can buy ETFs that track exotic markets such as Brazil, Eastern Europe, Taiwan, and even Korea – areas that historically have been difficult for small investors to gain access to.

After the launch of the first Exchange Traded Fund (ETF) on the New York Stock Exchange, and the subsequent successful development of the US ETF market, the European ETF market is today one of the fastest-growing segments of the European asset management industry.

There are now more than 27 asset management companies offering around 376 ETFs on 16 stock exchanges. Assets under management in Europe have risen by more than 28% since the end of 2006, standing in excess of $115 billion as at end-August 2007 as increasing numbers of investors, professional and private alike, take advantage of these investment vehicles.

What are the downsides of ETF’s?

As ETFs and ETCs are passive investments mirroring a market or index, your investment’s success will depend entirely on the fortunes of the market and/or index in which you are invested –if they go down, your cash will follow them.

Even though there is no stamp duty and costs are significantly lower than those associated with traditional unit trusts and OEICs, the price advantage may not always be as big as it initially appears –as trading costs could quickly add up if you are investing regular sums of money. In such cases you may well be better going with a traditional fund but for lump sum investors they offer good value for money.

Pros

ETF’S have low annual expenses, especially in relation to mutual fund charges.

Typical ETF administrative costs are less than two-tenths of one percent (or 20 basis points) per year, compared to the more than 1 percent annual costs of some mutual funds, according to Nasdaq.

ETFs can also be more tax-efficient. They only generate taxable capital gains when sold, unlike actively-traded mutual funds that annually pass through taxable capital gains.

ETFs can be bought and sold through a broker without restriction during the trading day. This gives investors more flexibility, especially when compared to mutual funds, which only trade at the end of the day.

ETF investors CAN use risk-management strategies like stop-loss orders, which call for the buying or selling of securities when they reach a particular price, and limit orders, which set the maximum and minimum purchasing and selling prices, he says.

Cons

That the bid-ask spreads (the difference between the bidding and asking price) on ETFs can be large with smaller assets under management. The smaller the spread, the lower the cost. ETFs are not as, say, liquid as small-cap stocks, so you may not get the ETF at Net Asset Value (NAV). This means you could overpay for the portfolio, or selling it for less than it is worth.

Emotional reactions to events in one major company within the sector can amplify the short-term trading of ETFs. A price drop in a company like Apple can trigger the sale of ETFs that include its stock, potentially resulting in increased volatility.

Purchasing shares of an ETF means you get “the good, the bad and the ugly” of the companies within the fund.

Costs

Most ETFs levy lower annual charges than even the cheapest traditional tracker funds but as with stocks, you have to pay a commission to buy and sell ETF shares, which can be a problem for investors who trade frequently or invest regular sums of money.

The popularity of ETFs in the UK is rising but they are still not as popular as more traditional investment funds. A reason for this could be that they do not pay commission to financial advisers. In regards to the annual charge to investors, ETFs are significantly cheaper than the vast majority of OEICs and unit trusts.

Costs vary from fund to fund, but they can be as low as 0.1% but remember there will be stockbroker costs. In addition there are no stamp duty costs with ETFs.

Exchange Traded Commodities

ETCs are simple and transparent open-ended securities that trade on regulated exchanges. ETCs enable investors to gain exposure to commodities.

ETCs are very similar to ETFs because they are both open-ended, continuously traded and have multiple market makers. With ETCs, investors can gain access to a wide variety of commodities from oil to coffee, gold to corn and cotton to soybeans.