Exchange traded funds: profit from the City’s best-kept secret

Exchange traded funds are in vogue, and for good reason, says Tim Bennett. Tracking an index or commodity, they buffer you from the hassles of direct investing and can deliver great returns

A decade ago, few retail investors had ever heard of exchange traded funds (ETFs). They started life in the US, when State Street launched the first few in 1993. For years they remained one of the City's best-kept secrets, used mainly by professional traders and fund managers, but over the last five years their popularity has exploded.

ETFs now account for more than $500bn of investments from a global market for mutual funds estimated at $8,000bn. Around 260 new ETFs hit the global market in 2007. There are now more than 600 available worldwide, from 28 different providers, say Deutsche Bank.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

This opens up some interesting investment opportunities. For example, from this summer you'll be able to track the performance of Egypt's stock exchange, the world's best-performing market over the past three years. Increased competition will keep pushing product fees down.

But it's also easy to get overwhelmed by the sheer volume of new offerings, or seduced into buying the latest "must-have" fund. So as with any investment, you have to choose your ETFs carefully and be aware of the potential pitfalls. We look at these, along with our current favourite funds.

What are exchange traded funds?

ETFs, or the newer exchange-traded commodities (ETCs), are just funds that issue shares to investors. Rather than tracking the performance of a single company, an ETF share tracks an entire equity index, sector, commodity, or even a foreign currency, without the expense or hassle of investing directly in the underlying products.

Take one of the biggest and oldest ETFs in the world, the US-listed SPDR S&P 500 (AMEX:SPY). This tracks the performance of America's top firms as represented by the S&P 500 index simply through owning one or more "Spider" shares (currently costing around $133 each). What's more, you get that broad exposure for an expense ratio the amount deducted from your investment to manage the fund of just 0.1%, plus your usual broking charges.

That compares well to an actively-managed S&P 500 fund, for which you could be paying ten or twenty times that amount, plus an upfront fee or even to a passive unit trust, where annual charges are typically around 1%. Now the expense ratio for the SPDR ETF is exceptionally low. But even the UK's biggest ETF provider, Barclays Global Investors (which shares more than 70% of the UK market with just one rival, SocGen's Lyxor), only charges 0.35%-0.75% on its range of iShares.

Another perk on most UK ETFs is that, unlike conventional shares, you don't have to pay the usual 0.5% stamp duty on the purchase price. And just like many other shares you can pop ETFs into an Isa or Sipp, shielding any capital gains from tax.

Exchange traded funds: a word of caution

No product is perfect and these are tracking products, so you won't do better, or worse, than the index or commodity being followed. You may not even achieve exactly the performance of the underlying asset, or group of assets, because of tracking error. A fund offering a FTSE 100 ETF, for example, may be invested in most, but not all, of the underlying shares, so its performance will diverge slightly from the index. But this is becoming less of an issue now that funds are able to make greater use of derivatives.

Next up is currency risk many of the most popular ETFs can be bought in your currency of choice. But newer products are often only available in US dollars. But that shouldn't necessarily put sterling investors off. Although the dollar is currently weak, sterling too is now on the slide as the UK economy falters, so you shouldn't suffer serious currency losses.

There's also the issue of diversification you may get less than you think. Take the exotic sounding PowerShares Lux Nanotechnology ETF (PXN). A glance at the fund fact sheet on www.powershares.com reveals that it only invests in 23 stocks, ten of which account for just under 60% of the ETF, most of them large, well-known S&P 500 names.

Finally, watch the bid-to-offer spreads. Like all shares there is a gap between the buying price and the selling price of ETF shares, which narrows as a fund gets more popular. On the new db x-trackers FTSE 250 (XMCX) the spread is about twice that on the more established iShares FTSE 250 (MIDD). Where there is a big spread, consider shopping around to see whether a similar product is offered more cheaply by other providers, but always check the "fund constituents" part of the fact sheet to check whether two ETFs with a similar sounding name do the same job.

Exchange-traded funds: so what's on offer?

Equities are easily the biggest ETF class. There is an ETF for most of the major indices in every developed economy. But with recession threatening the West, we prefer emerging markets.

Here there are several possibilities the iShares MSCI Emerging Markets (NYSE:EEM) fund offers exposure to a broad range of emerging markets. For a purer play on the "big four" of Brazil, Russia, India and China, there is the iShares FTSE BRIC 50 (NYSE:BRIC). Or you can specialise even further Brazil trades on a lower p/e ratio than China and India, but offers strong growth prospects, so Lyxor Brazil (Ibovespa) (LSE:LBRZ) looks a good bet. And although struggling just now, Japan's stockmarket remains a bargain long term and can be tracked using iShares MSCI Japan (NYSE:EWJ) or db x-trackers MSCI Japan (XMJP), which is priced in sterling but has a slightly higher expense ratio.

Exchange traded funds: fixed income

You can also invest in fixed-income products. iShares offers products that track both government (LSE:IGLT tracks a broad range of UK gilts) and corporate bonds (LSE:SLXX follows investment-grade corporate bonds).

But the return from gilts can be pretty dull and with the credit crunch in full swing, we are nervous of corporate bonds in general. That said, the recent indiscriminate selling of bonds by US investors, coupled with the prospect of further US interest-rate cuts that are usually good for bond prices, has thrown up some interesting opportunities among safer municipal bonds, as discussed in last week's issue. The ETF we like here is Barclays iShares S&P Municipal Bonds (AMEX:MUB).

Exchange traded funds: commodities

At MoneyWeek we're big fans of commodities, thanks to limited supply and growing demand, much of it from the industrialising emerging markets. There are essentially four categories: base metals, such as copper, nickel and tin; precious metals, such as gold; the softs, such as orange juice and cocoa; and agricultural commodities, which include wheat and soybeans, or cattle and pigs.

Using ETFs you can follow a specific commodity we like gold and silver, both safe havens in times of turmoil and now available from ETF Securities in sterling via LSE:PHGP and LSE:PHSP. Grains are also in high demand, thanks in part to aggressive biofuels targets good bets are wheat (LSE:WEAT) and corn (LSE:CORN), which both follow Dow Jones agricultural sub-indices.

Or you can opt for an ETF that tracks a basket of commodities. Right now we would avoid the industrial metals, such as copper and lead, because a slowing global economy may dent short-term demand. We prefer softs instead, which can be played via LSE:AIGS and the mixed basket of grains represented by LSE:AIGG. Or for a diversified play on agriculture, there's LSE:AGAP, which gives exposure to soybeans, cotton and sugar, among others.

Exchange traded funds: currencies

With Western currencies particularly the US dollar under pressure from falling interest rates, now is a good time to place down bets against the greenback and up bets against some of its rivals.

Currency ETFs, such as the Powershares Emerging Markets Sovereign Debt Portfolio (AMEX:PCY), tracks 20 emerging market currencies via a Deutsche Bank index that has doubled in the last four years. For those who believe the US currency will suffer more short term than the euro, there's the Rydex Eurotrust (NYSE:FXE). Lastly, to bet that the long-suffering yen will rise as carry trades unwind, there is the Japanese Yen Trust (NYSE:FXY).

Exchange traded funds: structured products

These products, which offer more exotic payoffs than conventional ETFs, are spreading like wildfire. But be aware that the expense ratios tend to be higher than most ETFs (up to 1% in some cases), and bid-to-offer spreads can be wide on the more unusual products. Our advice is always double-check charges and spreads via your broker before diving in and make sure you understand the product's payoffs using the fact sheet available at the provider's website. It is also worth checking if you can achieve a similar result for less cost using spread bets.

For equity investors who want to profit from falling share prices, there are products such as the Proshares Short S&P 500 (AMEX:SH), which rises as the S&P 500 falls, or even the Proshares Ultrashort S&P 500 (AMEX:SDS), which rises at twice the rate that the S&P falls. They also offer similar products focused on other indices and sectors. And for those who share our view that, short term, the Chinese market may continue to fall, there is the Proshares Ultrashort FTSE/Xinhua China 25 (AMEX:FXP).

For more information on these products, see below for providers' websites. Note that for some of the more unusual currency and structured products you'll need to phone your broker to set up a deal.

Exchange traded fund providers

Barclays iShares

ETFsecurities

Deutsche Bank

Socgen Lyxor

Rydex Investments

ProShares

PowerShares

State Street (SPDR)