A Guide to ETFs

An ETF is an investment fund that is traded on a stock exchange.

The information provided here is taken from iShares by Blackrock’s ‘Investors Guide to ETFs’.

The aim of an ETF is to track the performance of a specified index (like the FTSE 100) and to provide you with the same return as that index, less fees. Like a fund, your ETF investment gives you access to a portfolio of companies (shares), bonds or other asset types (such as commodities or property).

Like a share, an ETF is bought and sold on a stock exchange. Consequently, ETFs offer you the best of both worlds – the diversification of an investment fund, with the easy tradability of a share. Like all investments, your capital and income is at risk. The liquidity of the products is not guaranteed.

Are ETFs Popular?

Since the launch of the first ETF back in 1993, the growth of the ETF industry has been phenomenal, as you can see from the chart. Globally, there is now around $2.0 trillion invested in ETFs. Within Europe, the popularity of ETFs has soared over the past five years, with around $351 billion invested in ETFs today.

Pension funds, government agencies and private banks have been investing in ETFs for many years. Now, ETFs are becoming increasingly popular with private investors, keen to take advantage of the many benefits offered by this cost-effective and flexible investment solution.

Are all ETFs the same?

No. Broadly speaking, there are two types of ETFs and the difference between them relates to what the ETF actually ‘owns’.

PHYSICALLY-REPLICATING ETF

Physically-replicating ETFs hold the securities of the index that is being tracked, providing the investor with the security of actually owning the securities. There are two tracking techniques: full replication, where all the constituents are held in the weighting defined by the index or an optimised approach where not all the index constituents of a large index are held, as full replication could be less efficient and costly.

DERIVATIVE-REPLICATING ETF

A ‘derivative-replicating’ ETF holds a Financial Derivative. Instrument (FDI), usually a so-called performance swap. Under such contract the ETF receives from a counterparty a payout which is equal to the index return the ETF is replicating, minus a fee (the ‘swap spread’). Typically, derivative-replicating ETFs are riskier than physically-replicating ETFs, because of their exposure to the swap counterparty. That said, derivative replicating ETFs can be a good way of gaining exposure to markets that cannot be accessed through physically replicating funds, such as commodities and some hard-to access emerging market countries.

Over recent years, a number of ETF providers have begun moving to a physically replicating model, reinforcing a view that on balance, physically replicating ETFs generally provide you with a more robust investment solution. This view is attributed to the high level of transparency and low complexity of physically replicating ETFs. Indeed, the vast majority of the ETFs currently offered by the UK’s predominant ETFs provider iShares, are physically-replicated.

Diversification essentially means ‘don’t put all your eggs in one basket’. If you can spread your investments over a number of different asset classes (shares, bonds, property etc.), you provide greater opportunity to achieve more consistent returns, often with a lower level of risk.

Diversification ETFs

Diversification - UNDERSTANDING RISK AND RETURN

In the past, many investors concentrated solely on the ‘return’ on their investment – i.e. whether they made a profit or a loss. However, there is a growing acceptance that you should concentrate on both return and risk – i.e. whether or not the investment has provided you with the actual return you expected when you first invested, and to what degree your initial investment (your capital) has been subjected to the chance of losing money. With this in mind, the aim of your investment should be to obtain the highest return on your investment, for the lowest risk. Diversification can help you reach this optimum balance of risk and return, as it spreads your investments over a wider range of asset types, countries and sectors. The theory behind this is that at different points in time, different asset types (or countries, or sectors) will perform differently – if you have exposure to a broad range, then over a period of time the poor performance experienced in one type of asset will be compensated for by stronger performance in another, and vice versa. This lowers the risk for negative overall performance at any one point in time.

Let’s consider the example above. The diversified portfolio B targets a similar level of return to portfolio A, but importantly it does this with considerably lower risk, potentially making it a more attractive investment. This is shown in the diagram opposite. With ETFs, this example can be expanded upon. As we explained previously, physically-replicated ETFs hold the underlying securities (like shares or bonds) listed in the index that they track. This means that ETFs are by their nature already highly diversified and consequently can offer you an attractive risk/return balance. Moreover, ETFs are available across different asset classes and geographies, which we will now explain further.

Efficiency and access

As we said earlier, ETFs are as easy to trade as a share. This means that you can easily make or add to an investment, or sell your investment. In addition to being an efficient way of investing, ETFs also give you greater access to investment opportunities across different asset types and regions. So, whatever your investment goals, there is an ETF that can help you achieve them. You can invest in ETFs that track equity indices, bond indices, commodity indices and property indices. There are literally hundreds of ETFs available which cover virtually all major asset classes. ETFs are available for domestic and global investments, or country and regional investments. ETFs cover most sectors too – from technology to telecommunication companies, clean energy to consumer stocks. You can invest in bonds issued by governments and companies, both in developed and in emerging markets.

Cost-effectiveness

Investment products can sometimes charge high management fees and other costs. These costs can cancel out any gains made by your investment and can sometimes even lead to losses. That is why ETFs have one primary cost element – the Total Expense Ratio (TER). The TER represents the total cost to you of holding your ETF investment for one year. The TER covers all annual costs relating to fund management. The average TER is usually higher than that of traditional passive funds. One of the reasons for the higher TER is that ETFs can be traded throughout the day, while traditional passive funds trade only once a day. The intra-day trading mechanism comes at a cost partly because the ETF provider needs to pay a listing fee to the stock exchange where the ETF is made available to clients. The TCO argument looks beyond TER, including other costs related to entering, holding and exiting a specific investment. Active and index tracking mutual funds can usually be accessed at a single valuation point each business day at the net asset value adjusted for applicable dealing charges and fees.

The TCO is calculated by adding all the costs of an ETF and subtracting all the revenues generated over the same time period. It considers external factors such as the explicit costs of trading, and internal factors such as rebalancing costs and securities lending revenue (see figure below).

Total Cost Of Ownership

TOTAL COST OF OWNERSHIP: INTERNAL AND EXTERNAL FACTORS

Internal factors include both costs to the fund and revenues received by the fund for the same time period. These internal factors include TER, rebalancing costs and any securities lending revenue generated. External factors are costs to the investor deducted at the time of purchase and sale of an ETF and include trading or creation/redemption costs along with brokerage fees and taxes. Trading costs are reflected in the bid/ask spread when buying an ETF on-exchange or over-the-counter.

When a comparison between ETFs and traditional passive funds is performed based on the TCO, as opposed to the TER, the costs of the two types of instruments becomes much more comparable. Usually, the choice of one or the other is a function of the investment horizon of the client.

Transparency

With many types of investment, there can sometimes be a lack of clarity as to where your money is actually invested. There can also be considerable uncertainty as to whether or not your investment is meeting its targets, as there is little information on how it is performing day-to-day. Many ETF providers publish daily a thorough disclosure of holdings and structures. For example, for physically-replicated ETFs, the list of all the securities held by the fund is published. For derivative-replicating ETFs, the full list of holdings the investor is gaining exposure to through the use of Financial Derivative Instruments (the performance swap) is published. In addition to that, a list of the securities used to mitigate the swap counterparty risk of default is also provided. In this way, you can see exactly where your money is invested. Full performance information, so you can see exactly how your investment is performing on a daily basis is also accessible in most cases.

What are the risks with ETFs?

It’s important to understand that ETFs are not guaranteed products – just like any investment in the stock or bond market, your initial investment is subject to loss. As there are many different types of ETFs, there are some that are riskier than others. If you invest in an ETF that holds securities in a currency other than your own (for example, a Japanese equity ETF), your returns can also be affected by movements in the exchange rate (GBP vs. JPY). There are some ETFs that provide currency hedging to minimise this ‘currency risk’. ETFs are designed to track an index – i.e. they buy the same securities as that index and attempt to replicate the returns, minus the cost (fee) of the fund. There is a risk that there can be a divergence between the return of the index, and the return of the fund. However, it should be remembered that it is impossible for any investor to invest directly in an index.

How do I buy ETFs?

You can buy and sell ETFs via a stockbroker or their DIY investment platform. Your adviser or customer support will be able to explain how to set limits on the purchase and sale prices that transactions are completed at. Please remember that as with all investments there are risks involved with buying and selling ETFs. Your investment can go up and down and your capital is at risk.

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