Exchange-traded funds: A cheap and simple trading tool

Financial watchdogs in Washington, London and Basel are worried. In the last few years exchange-traded funds (ETFs) have exploded in popularity. Regulators fear that they pose a "systematic risk" to the financial system. Even BlackRock, the world's biggest ETF provider, has its doubts. "I fear that an exchange-traded product will break down one of these days and the worry is that it will poison the entire sector," says Mark Wiedman, head of the firm's iShares division. So what are ETFs and should you be worried?

ETFs are financial instruments designed to track the performance of an underlying asset from stockmarket indices to individual sectors to currencies without the expense and hassle of direct investment, or the cost of paying an active fund manager.

You can buy and sell them through an online broker as easily as you would a FTSE 100 share such as Tesco. At first used largely by instutions, they've become more popular with small investors over the last decade, as people have woken up to the importance of keeping costs down.

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In the US, the total number of assets in ETFs has grown by 750% to more than $1.3 trillion in the last ten years. ETFs are also booming in the UK. BlackRock, the largest provider of ETFs in Britain, has seen demand for its products grow by 175% over the past two years, with £746m in its ETFs at the end of 2011.

So why are regulators worried? One issue is with specific types of ETF. Problems here usually come down to investors failing to understand how they work. Leveraged ETFs, for example, offer two or three times the return on a given index. But it's crucial to understand that these are short-term trading tools. They are rebalanced daily, which effectively means that if you hold them for more than a day, they stop tracking as you might expect.

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Commodity-tracking ETFs can also cause confusion. Physically backed ETFs track the spot' price, and are therefore quite transparent. But many commodity trackers are priced off the futures markets, which can result in unexpected costs when they have to roll over' into the next contract. Again, this comes down to knowing what you're buying if you don't understand the terms backwardation' and contango', then don't buy ETFs that track futures.

Another issue is the difference between synthetic' and physical' ETFs. Synthetic ETFs use derivatives to track an underlying index, whereas physical ETFs own the index's underlying stocks. The worry with synthetics is that they introduce counterparty risk if the company providing the derivative goes bust, the ETF could end up in trouble.

However, also be aware that physical ETFs sometimes lend securities out (to short-sellers perhaps) for a fee. In this case, some of the ETF's holdings will temporarily be replaced by alternative stocks, held as collateral. The risk here is that the borrower of the stocks will fail to return them, forcing the ETF issuer to sell the collateral.

Because the collateral is different from the stocks in the index, there could be a shortfall. But as Paul Amery, editor of www.indexuniverse.eu points out, actively managed funds also lend securities or trade in derivatives. And the focus on ETFs means that they are often far more transparent about these activities than their actively managed peers.

So while it's important to be aware of these dangers, they shouldn't be overstated. ETFs have long been a MoneyWeek favourite and if you pick the right one, you'll enjoy plenty of advantages. They're cheap: the typical annual cost is less than 1% of your investment, with some charging as little as 0.1%, against an average total expense ratio (TER) of 1.68% for a unit trust. Another benefit with ETFs is that, unlike most other shares, you are not liable to pay the 0.5% stamp duty. Which means an ETF in an Isa wrapper is one of the most tax-efficient investments around.

The ETFs to buy into now

Regular readers won't be surprised to hear that we think China is in for a slowdown this year. A slew of recent data shows that growth in the world's second-largest economy is tapering off. That will have a major impact on commodity markets, which have seen prices driven higher largely by China's seemingly insatiable demand.

Even a so-called soft landing', where China's economy wavers but avoids a deep recession, would hit prices. One way to play that would be by shorting the currencies of major commodity-producing nations.

Australia and Canada spring to mind, because as well as being commodity-dependent economies, both countries have serious housing market bubbles. The ETFS Short CAD Long USD (LSE: SCDP) ETF gives you a built-in short position in the Canadian dollar against its US equivalent. Similarly, you can short the Aussie dollar via the ETFS Short AUD Long USD (LSE: SAUP) ETF. Be warned that currency markets are volatile, so set stop-losses and watch your position closely.

Another way to play the global currency wars' where central banks are competing to out-print one another is to shun fiat currencies altogether, and invest in gold. The ETFS Physical Gold (LSE: PHAU) ETF can be held in an Isa and is physically backed by gold held in HSBC's vaults. The annual management fee is 0.39%.