ETFs are all the rage right now. Here's what you need to know

ETFs are cheap and diversified and there’s plenty of choice, giving investors portfolios with varying levels of risk.

Trackers, like active funds, can be combined to build a range of portfolios, whether you’re looking for a particular level of risk or a specific outcome such as a certain level of income. Passive funds typically appeal to investors focused on investment costs and disillusioned with the performance and value of active managers.

Access to passive investment strategies has risen dramatically in the past few years, partly due to the increasing number of exchange traded funds (ETFs) available. ETFs have multiple attractions: they’re cheap, they’re diversified and there’s plenty of choice, enabling investors to put together passive fund portfolios with varying levels of risk.

What is an ETF?

ETFs are investment funds listed on a stock exchange and traded like equities. Most ETFs aim to track the performance of a particular index of stocks, bonds or other assets. This approach differs from active management, where the aim is to deliver a return superior to the market via the tactical management of a fund.

In contrast, ETFs simply aim to provide investors with a return as close as possible to the underlying market (it is always marginally reduced by the annual ETF fee). So, for example, if the FTSE 100 index goes up by 10 per cent in a year, an ETF tracking this index should provide investors with a 10 per cent return minus fees.

Passive funds can be an easy way to diversify your portfolio. For example, buying an ETF that tracks the S&P 500 index is comparable to buying a small part of each of the US index’s 500 companies – but at a much lower cost than if you bought each stock separately. Passive funds in general also work well if you want to gain specific exposure where active managers may struggle; again, the US large-cap market is a good example as it is so extensively researched.

Types of ETF

There are two main types of ETF: physical and synthetic. Physical ETFs are also known as ‘direct’ or ‘cash-based’ ETFs and they either fully or partially replicate the index being tracked. ‘Fully replicated ETFs hold every investment, in proportion, within the index they are looking to track. For example, a fully replicated S&P 500 ETF would hold all 500 companies in the index,’ explains Danny Cox of Hargreaves Lansdown. ‘Partially replicated ETFs do not hold every investment in the index; instead the manager chooses a portfolio designed to perform in line with the index, but without holding every stock or bond.’

Synthetic ETFs are also known as ‘indirect’ or ‘swap-based’ ETFs. This type of ETF doesn’t hold any of the assets within the index being tracked; instead the fund will buy a type of derivative called a ‘swap’ to replicate the index. As a consequence it can be slightly more risky, due to counterparty risk. This is the risk that the swap provider (usually an investment bank) will run into financial difficulties, although this can be reduced by the third party holding collateral – stocks, bonds or cash – unrelated to the index but of equal value to the ETF.

Costs

In common with other tracker funds, low costs tend to be one of the key attractions of ETFs. Investors will pay both transaction costs (when buying or selling ETFs through a broker or fund platform) and an annual management fee charged by the provider to cover the cost of managing the fund. An ETF tracking the FTSE 100 might cost as little as 0.1 per cent per year, compared to a typical cost of 0.75 to 1.25 per cent for an actively managed fund trying to beat the index.

However, some experts argue that although ETFs can be one way to construct a low-cost passive portfolio, open-ended index tracker funds (Oeics) can offer the same exposure at lower cost.

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But Robert Lockie, chartered wealth manager at Bloomsbury Wealth, takes the view that the type of wrapper (ETF or Oeic) in which you hold the portfolio assets is far less important that than the nature of the underlying assets within them. ‘If, for example, UK small cap equities have a bull run, investors who own that asset class will show broadly similar returns, irrespective of whether they own them via an ETF or some other wrapper,’ he says.

The main difference between ETFs and index tracker funds is that the latter are priced once a day and are held in the same way as a normal investment fund, while ETFs are priced throughout the day and traded like a stock on an exchange.

Jason Hollands, managing director at Tilney Group, suggests investors take a pragmatic view in constructing a passive portfolio. ‘There’s been a pretty aggressive price war between providers of index-tracking Oeics; in some areas the lowest cost options might be Oeics rather than ETFs, and you can also save yourself a dealing fee,’ he says. ‘True, an ETF will offer intra-day rather than daily pricing, but that’s only really relevant for those who are pursuing a day-trading approach, rather than long-term investors.’

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How closely an ETF matches the index it’s tracking is measured by its ‘tracking error’; the most efficient funds have a low tracking error. When it comes to selecting an ETF with a fairly vanilla strategy – for example one tracking a major equity index such as the FTSE All-Share – costs will have a significant impact on the tracking error, as these will account for most of the deviation from the index in question. The tracking error can also be affected by transaction and rebalancing costs, sampling, and cash drag from dividend distributions.

Trackers vs active funds

There are cost differences between the various tracker funds and ETFs, as well as between active and passive funds as a whole. But Albion Strategic Consulting found in 2015 that for a typical passive portfolio invested 60 per cent in equity and 40 per cent in fixed interest index funds, the total cost (underlying asset costs plus impact of portfolio turnover) amounted to 0.48 per cent, while an actively managed equivalent cost over 0.8 per cent more at 1.29 per cent. 

‘The active version must therefore deliver at least this amount of return on average every year to deliver a superior outcome,’ says Lockie. ‘The historical evidence shows that this is a rare occurrence and when it does happen, it is very difficult to identify in advance who the “winning” managers are.’

However, research by independent financial adviser Chase De Vere contradicted this view. It found that most tracker funds underperform when compared with the actively managed funds in their investment sector. According to this research, with the exception of North American and UK mid-cap investments, no tracker fund has generated first- or second-quartile performance over the past 10 years; in other words, trackers have produced below-average long-term performance.

Patrick Connolly, certified financial planner at Chase de Vere, says: ‘The popularity of tracker funds is due to their low charges and the general perception that these should result in them performing well over the longer term. But our research shows that this could be an incorrect assumption.’

Building a passive portfolio

Asset allocation – the way you divide your investment among different asset classes – will have a significant impact on the way your passive portfolio performs. Some asset classes complement each other because they tend to perform differently under certain economic conditions.

For example, equities generally do well in boom times, while bonds give you a stream of income and offset some of the volatility you might see from owning stocks. Commodities can be a good bet during periods of inflation, while many investors hold gold as insurance against economic collapse. It can also be a good idea to diversify geographically, rather than taking a punt that a particular country will perform well.

One of the standout advantages of using ETFs to build a passive portfolio is access to significant product innovation, particularly in the arena of factor funds and so-called ‘smart beta’ funds.

Smart beta funds are led by managers who claim they take a more scientific approach to investment that offers the best of both active and passive strategies. Essentially these funds are index trackers, but instead of tracking a familiar index, smart beta funds follow their own specially devised benchmarks. The creation of the formula for such a benchmark is an active investment strategy, but thereafter the fund passively tracks the index created: this puts smart beta funds somewhere between passive and active styles.

‘These products combine some of the benefits of traditional tracker funds in terms of lower costs than active management, diversification and the removal of the uncertainty of human judgment; but they enable investors to achieve much greater control over the type of exposure they want – for example, to companies with particular yield, balance sheet, earnings growth or valuation characteristics,’ explains Hollands.

There’s no single asset allocation model that works for everyone. Your investment goals will be a major influence. Are you investing for growth or income? What is your investment timescale? How much risk are you happy to take? In general, a cautious portfolio will have a higher weighting to fixed income and less to equities, and a more adventurous portfolio will have the reverse.

When it comes to choosing ETFs, investors may not understand why they should choose one fund over another; but not all ETFs are created equal.

There are several key questions investors should ask when picking an ETF:

• First, who’s the provider? The provider’s size, scale and experience in the ETF market should all be taken into account.

• Does the ETF capture the exposure you want – which index is being tracked? If it’s a smart beta fund, is it offering the right balance of focus and risk? 

• The structure of the ETF will also be a deciding factor. Most of the major ETF providers in Europe, including iShares, Vanguard and HSBC, favour physical replication over synthetic ETFs.

• You should examine the liquidity of the ETF – how easy is it to trade when you want to?

• Finally, assess both management fees and transaction costs for trading the ETF. Although ETFs tend to have low costs compared to active funds, charges will vary from one ETF to another.

Morningstar has a screening tool whereby you can search for its highest-rated ETFs across the spectrum of sectors. Alternatively, Hargreaves Lansdown publishes a list of the most popular exchange traded products held by the firm’s clients, while Barclays Stockbrokers compiles a weekly list of the most-purchased ETFs. Neither list should be taken as financial advice, but they can be a good starting point for investors baffled by the range of options. 

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