John C Bogle, the American founder of the index fund manager Vanguard, launched the first passive index-tracking fund in 1976. It was designed to track the S&P 500 index, and still does so today under the name of Vanguard 500 Index Fund.
The new fund was known as Bogle's Folly, because of Wall Street brokers' obsessions with active management at the time. But passive investing has gained popularity in the intervening decades, and one increasingly common way of tracking an index over the past 10 years has been through an exchange traded fund, or ETF.
Exchange traded funds can be bought and sold on an exchange in the same way as shares. The portfolios track an index in a similar way to an index tracker fund, with shares created to meet demand.
To find out which exchange traded funds Russ Mould of AJ Bell thinks would suit investors with differing time horizons, read: How to integrate an ETF into your portfolio.
How do etfs work?
An ETF is listed on a stock exchange and can be traded any time the exchange is open, so investors can have precise knowledge of exactly how their investment is performing.
The aim is to provide the same return as an underlying benchmark - which could be an index such as the FTSE 100, the MSCI World or many others.
How closely the fund matches the index is measured by its 'tracking error', and the most efficient funds will have a low tracking error.
The largest sources of tracking error are typically the expenses incurred in trading and tax deductions on dividend payments.
Exchange traded funds are typically described as being either 'physical' or 'synthetic', but it may be more readily understandable to think of them as 'direct' and 'indirect', respectively.
A physical ETF is directly invested in the stocks making up the index it aims to follow. So a physically replicating FTSE 100 ETF will invest in stocks from that index.
It holds different amounts of each, weighted according to the market capitalisation of the company and therefore its position in the index.
In cases where there are simply too many stocks to hold, usually when dealing with a very big index such as the MSCI World, an ETF might aim to replicate as closely as possible but leave out some of the smaller components. This might lead to a greater tracking error, however.
Synthetically replicated ETFs do not invest directly in the underlying assets of the relevant index.
Instead, the ETF provider will enter into a 'swap' agreement with another firm, such as a bank, for example, that promises to pay them the return of, say, the FTSE 100.
Under such an agreement, if the index returns 1 per cent, for example, the swap provider will pay that return to the ETF provider.
If, however, the FTSE drops 1 per cent in the agreed time, the ETF provider would have to pay out that amount to the company they agreed the swap with.
Exchange traded funds are attractive to retail investors for several reasons. First, they offer a way of diversifying a portfolio without having to personally purchase hundreds of individual stocks.
They may also provide access to more esoteric overseas stock markets that are closed to retail investors.
It is also possible to track the price of a commodity, or a basket of commodities, in a similar way using exchange traded commodities (ETCs).
Here, we will limit discussion to pointing out that they offer a valuable route into the asset class - particularly as conventional commodity investment often escapes the grasp of retail investors, owing to the amount of capital often required and the risk of having to physically receive the raw materials.
Mark Johnson, head of UK sales for iShares, says one attraction is the sheer variety of ETFs that exists. 'There are now 1,400 in Europe and 5,000 globally. There's a lot of specificity you can achieve through an ETF that you may not be able to attain with conventional actively managed funds.
'You might, for example, have a view that emerging markets are attractively valued, but not like all of them. The sheer variety of choice in ETFs allows you to be quite bespoke as to which market you access.'
For example, Money Observer's ETF data, on page 96 of our September magazine, includes those focusing on single countries as well as ETCs tracking the soybean oil and livestock markets, among others.
There are also numerous ETFs following specific industry sectors (from healthcare to utilities), or screened for particular themes or styles (minimum volatility, for example).
Cost is another key factor. According to Russ Mould, investment research director at AJ Bell, ETFs are on average significantly less expensive than managed funds.
While ETF total expense ratios average around 0.35 per cent a year, a typical 'clean' managed fund costs around 0.75 per cent - more than twice as much.
Theoretically, lower fees translate into greater returns. If you pay 0.35 per cent rather than 0.75 per cent each year for active management that fails to beat an equivalent index, that is essentially equal to a 0.40 per cent uplift in performance.
ETFs are also exempt from the 0.5 per cent stamp duty that applies to dealings in shares listed on the main market of the London Stock Exchange.
Mould adds: 'More experienced and sophisticated investors can use ETFs to hedge a portfolio against an event, or even benefit when an index or basket of securities falls in price.
Some ETFs are known as short ETFs and perform inversely to the assets they are tracking - so if a stock index falls, the ETF will rise in value, and vice versa.'
Unlike investment trusts or funds, in the UK providers of ETFs must show what the fund is invested in at all times. The former usually only disclose that on a monthly basis.
Given that transparency and the ability to trade ETFs at any point during the day, they become very appealing to more active investors.
However, one of the big pulls of ETFs - the variety of exposures they allow - can also be the biggest stumbling block for direct investors.
The challenge is to stay focused on how much risk you want to take and your investment objective.
Mould explains: 'The fact that you can now trade Brazilian equities, American junk bond debt or wheat does not mean you have to do so. Always ensure any investment through an ETF fits with your overall investment strategy, target return, time horizon and appetite for risk.
'In each case investors need to watch for the tracking error and tracking difference shown by an ETF. Tracking error is a term used to describe how smoothly an ETF mirrors the benchmark it is following, and ideally there should be limited volatility here.'
Exchange traded products come with their own set of risks. Because they replicate the price movements of their underlying benchmark, ETFs provide exposure to the market's downs as well as its ups, so there's nowhere to hide if ETFs fall, and ETCs are similarly vulnerable.
Synthetic ETFs also include an element of inherent counterparty risk. If the swap partner goes bust, for example, it might not be able to provide the promised return.
However, firms will put assets aside that could be used to make payments if they can't meet their obligations.
So while they allow low-cost and transparent exposure to all sorts of markets, ETFs are by no means risk-free; indeed, there's a danger they could tempt investors to fall victim to what Warren Buffett says is one of the biggest mistakes in investing: excitement.
If you want to invest in an ETF please consider Interactive Investor, our sister site and award winning brokerage.
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