Sunday, 29 March 2015

Exchange Traded Funds - ETF's

If you have ever sat and looked at your investment portfolio, wondering why it seems to be that your mutual funds (unit trusts) are stagnant or simply lagging behind when markets around you are continuing to show growth then you may want to consider ETF’s (Exchange Traded Funds).  What exactly is an ETF? An ETF is a type of fund, some entity that owns assets (bonds, stocks, gold bars, etc.) and divides ownership of itself into shares that are held by shareholders. The shareholders indirectly own the assets of the fund, and they will typically get an annual report. Shareholders are entitled to a share of the profits, such as interest or dividends, and they may get a residual value in case the fund is liquidated. Their ownership of the fund can easily be bought and sold.

Why ETF’s? Firstly, in 2014 only 18% of actively managed funds actually beat the returns of the index they were measuring themselves against. Let’s use an investment in the FTSE 100 as an example. If you bought a traditional UK FTSE equity fund there was a very good chance that the fund performed worse than the FTSE 100 as a whole. This is because the investment managers job is to try and pick the stocks within the FTSE 100 that they feel are going to perform best, it’s difficult to do consistently as most funds will only hold 40-60 stocks thus there will always be around half the FTSE 100 that does not affect the performance of the fund. This results in a gap between the index performance and the fund performance. The second problem is that on average a managed fund investing in stocks will charge around 1.5% per annum in management fees. An ETF designed to track and match a specific index will cost around 0.2-0.5% per annum in management fees. So not only is there a better chance that your ETF will yield better returns than the managed fund but you will also have a smaller fee hurdle to clear before you start to make a profit. The third advantage of ETF’s is the trading cost. Many traditional managed funds will charge an entry fee of 1%-5% when you purchase the fund. Assuming you have a good quality investment platform the dealing charges to purchase ETF’s are usually no more than 0.2% of the amount invested. It’s a win, win, win situation.

There are still many good traditional investment funds out there, so they shouldn’t be discounted entirely but where available our client portfolios usually have around 50% of the value invested into ETF’s. There is a huge choice available with ETF’s that track the price of everything from different stock markets around the globe, precious metals, oil, bonds, property and many more. There are some pitfalls to be careful of when investing in ETF’s. The biggest for me is to only buy an ETF that has physical holdings as the underlying assets. As an example, if you wanted to buy gold, some ETF’s will buy and store the physical gold bullion (usually stored in London or Switzerland) while other ETF’s will buy a contract that matches the movement in the gold price (known as a derivative). I would only ever buy the physical gold ETF, that way, if for any reason there is ever a problem with the fund it has physical assets to back the share price of the ETF.

There are many providers of ETF’s, at the end of 2014 here were over 5,000 different ETF’s available but, as with most things, its best to buy from the big names. Companies such as Deutsche Bank, Vanguard, Wisdom Tree and iShares all have a large selection of ETF’s at competitive prices, you will, of course, require a trading account / platform to purchase them. By using these ETF companies you should avoid making any mistakes with your choice of custodian for the assets. Investment always carries risk, however, using ETF’s can provide a way to minimize costs and improve returns.

Have a great day, Andrew Lumley-Holmes

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