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Exchange Traded Funds (ETFs): a beginner's guide

Exchange Traded Funds Guide

Exchange Traded Funds, commonly abbreviated to ETFs, are a cheap and efficient alternative to investing in managed funds. An ETF will seek to track the performance of an index, usually a stock market index, while charging investors a very low fee compared with a normal unit trust or other fund. Many ETFs can be held in a tax free ISA (if you are a qualifying UK resident). Unlike funds, ETFs are traded openly on stock exchanges: to all intents and purposes, they are just like shares, but instead of investing in a company, you are investing in an index.

By working through this Exchange Traded Funds guide, you’ll understand the following:

  1. What markets can you trade with ETFs?
  2. Why you should trade ETFs?
  3. When to choose a passive ETF over an actively managed fund
  4. The typical fees associated with an ETF
  5. Smart Beta ETFs
  6. When should you use ETFs in your investment strategy?
  7. What are Inverse and Leveraged ETFs
  8. How can you invest in ETFs?

What markets can you trade with ETFs?

One of the first – and most successful – ETFs to be launched was the SPDR 500, known colloquially as the Spider, which was listed by State Street Global Advisors on the American Stock Exchange in January 1993. Since then the market for ETF products has mushroomed, and you can now buy ETFs tracking most of the major stock market indexes, as well as many of the minor ones. ETFs are bought and sold every day by both private and professional investors, and represent a cost effective means of investing in a stock market index like the S&P 500.

Exchange Traded Funds can also let you invest in commodity markets. Companies like ETF Securities have listed funds that seek to track commodities futures markets, including individual commodities like oil and gold, and baskets of commodities futures, like agricultural commodities or base metals.

But it goes further than that: Exchange Traded Funds can be bought that represent specific sectors, like real estate or financial services. You can also buy ‘bear’ ETFs that go up when the market is going down (also called ‘inverse’ ETFs). These can be particularly useful if you want to hedge your positions, or would like to go short the market in expectation that it will fall.

The latest trend in the ETF market is for currency ETFs, an alternative to buying direct exposure to currency prices. These ETFs will tend to track the performance of a currency against either the US dollar or a basket of other currencies.

The range of Exchange Traded Funds available in the US is much larger than in Europe, as this is the market where they started, and the take up from investors has been higher. Buying ETFs on US exchanges is exactly like buying shares there. They will be denominated in US dollars and will not be eligible for inclusion in UK ISAs.

Why invest in Exchange Traded Funds?

Over the last 10 years ETFs have won market share from active funds because they are more likely to track their index. Active funds use an index as a benchmark that they should beat, but the reality is that most active funds fail to meet or even beat their benchmark, year in and year out. In 2017 a staggering 86% of active fund managers in the UK failed to beat their benchmarks. This represented a fourfold increase on 2016.

ETFs by contrast will seek to mirror the performance of an index, up or down, as closely as possible. There will be some variation, but not much. In addition, they charge much lower fees than active funds and can be traded like shares, on a stock exchange. There are no lock ups or redemption penalties as you might experience with some types of active fund strategy.

Like funds, UK-listed ETFs can be included in your ISA or SIPP. There is already a wide menu of ETFs available on the London Stock Exchange, with more being added every month. ETFs can also provide exposure to markets that would otherwise be more expensive to trade, like foreign markets, bonds, or even commodities.

Why choose a passive ETF over an actively managed ETF?

The number of active ETFs available on the market is still relatively small. They are listed and traded like normal ETFs, but rather than replicate an established index, they will instead seek to replicate an underlying fund. The idea here is that a stock market listed ETF, which can be traded like a share, will still offer the performance of an unlisted fund. This obviously only makes sense if that fund is closed to new investment or is one of the few that can perform consistently well.

Active ETFs will usually charge higher fees than passive ones.

What are the typical fees associated with Exchange Traded Funds?

ETFs will charge an annual management fee; holders of an ETF will pay a proportion of this, based on how long you keep it in your portfolio. You don’t need to hold it for a year to pay the fee. Having said that, ETFs fees are a lot lower than active funds, and even then, the big providers are currently engaged in a price war to reduce fees further.

Traders of ETFs will also have to pay capital gains tax, unless you are trading them in a tax free wrapper, like an ISA in the UK, for example.

Transaction fees for trading ETFs will also apply when you buy or sell them; this will be the same as investing in stocks and shares.

What are Smart Beta ETFs?

Smart beta ETFs use an index that has been constructed and is updated to meet specific investment needs. A good example would be an index that has been designed or modified to focus on stocks that are likely to experience dividend growth. Weightings in the index can be different from the normal price or market capitalisation of conventional indexes: for example, stocks might be equally weighted or on historic volatility.

The objective of the smart beta ETF is to produce superior returns, maximize dividends or reduce risks. These ETFs can bring with them higher management fees due to the bigger trading costs faced by the manager.

When should you use Exchange Traded Funds?

ETFs are a cheap and efficient alternative to gaining broad market exposure. They can easily form part of a broader, diversified portfolio. For example, if you don’t want to pick individual European stocks, but would like to achieve some basic European equity markets exposure, an ETF can do this for you.

Some might argue that an active fund could do this job for you, but you would need to be confident that fund is going to beat the index. In most cases, they don’t.

ETFs can help you to trade in an out of foreign markets, taking advantage of broad movements, rather than having to buy and sell individual shares and incurring foreign exchange risks and overseas dealing costs, which can be higher than trading in your home market.

ETFs can also be a good way to trade more unconventional markets, like commodities, without having to trade futures or use a Contracts for Difference account, which are more expensive and more risky options.

Inverse and Leveraged Exchange Traded Funds

ETFs are available that can help you trade a market more tactically:

Leveraged ETFs enhance returns or losses, usually by a factor of x2 or x3. You should be more cautious with these. If an index goes up by 3% in a week, a x2 leveraged ETF would rise 6%. This sounds good in practice, but it also means that losses are similarly magnified. Still, compared with margin trading, this is a less risky way of enhancing your returns.

Inverse ETFs are funds that behave in the opposite way to the index they track. They are a good way to trade an index on its way down. These are also available as leveraged funds. They can be a good way to make money if the market is in a bear phase.

How you can trade Exchange Traded Funds

An increasing range of ETFs is being made available to the investing public on major securities markets. You can buy and sell these every day using the same brokerage account you use to buy and sell shares or active funds.

If you are living in the UK, you can use ETFs inside your ISA or SIPP. Be aware that ETFs that use futures contracts to produce their performance – e.g. with a commodities ETF – will begin to vary from the index over time.

This represents the additional drag of fees on the fund from buying and selling the securities it needs to replicate the index. Hence, don’t be surprised that an ETF in your portfolio will begin to show some slippage after 3-6 months.

Here at The Armchair Trader, we feel that ETFs represent one of the simplest and cheapest ways to invest in indexes and commodities without opening a leveraged Contracts for Difference or spread betting account. Take a look at our broker directory to find a platform that gives you access to ETFs

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