ETFs: A cheap route to income

Exchange-traded funds can be a great way to gain exposure to an entire index, sector, currency or commodity. Here's everything you need to know about buying ETFs.

Exchange-traded funds (ETFs) are simple and useful. At heart they're just funds that issue shares to investors. Rather than tracking the performance of a single firm, 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 (NYSE Arca: SPY), or spider' as it is known. This tracks the performance of America's top firms as represented by the S&P 500 index.

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 20 times that amount and an up-front fee.

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Another perk of most British 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, shielding any profits from capital gains tax.

Let's not forget that ETFs can also offer income. With interest rates on cash deposits now so low, that's worth bearing in mind. Dividend ETFs are a cheap, diversified way to track dividend-paying stocks and offer a decent yield at the same time. As an example, the iShares FTSE UK Dividend Plus ETF (London: IUKD) offers a decent 4.6% yield and comes with an annual total expense ratio (TER) of just 0.4%.

Investors in emerging markets have cottoned on too the Wisdom Tree Emerging Markets Equity Income Fund (NYSE Arca: DEM) offers a yield of nearly 4% on a TER of 0.63%. Similar ETF offerings are available from State Street and BlackRock.

But before buying, be careful not all dividend ETFs are created equal. First, look under the bonnet to see the top fund holdings. The whole point of investing for income is to gain access to a steady, reliable cash flow and accept that you may be giving up big capital gains, at least inthe short term. The fund fact-sheet will tell you which sectors and firms the fund has bought.

High yield can also mean high risk. For example, the iShares FTSE ETF mentioned earlier targets the 50 highest-yielding FTSE 350 stocks and so holds a raft of insurance companies and travel operators hardly risk-free sectors. Meanwhile, the Wisdom Tree Emerging Markets ETF is 25% invested in Taiwanese and Brazilian financials.

Next, check whether the fund uses a market-capitalisation-weighting approach, or caps the maximum size of a single holding to, say, 5%. The danger with the first approach is that a few risky stocks can make up a disproportionately large chunk of the fund.

The best route to a sustainable yield is to pick ETFs that focus on stocks that are likely to be able to sustain or raise their dividends. The US Vanguard Dividend Appreciation ETF (NYSE Arca: VIG) looks for stocks with a ten-year track record of raising dividends. In Europe, the iShares Euro Stoxx Select Dividend 30 ETF (London: IDVY) only buys firms with a five-year track record of dividend growth.

Handle these ETFs with care

Certain types of ETF products seem to us to fly in the face of the feature that make these investments attractive in the first place: the fact they are simple to understand. We'd be wary of two in particular leveraged' and short' ETFs. They can be useful, but only if you know what you're doing.

Short ETFs are a way to bet on a market falling. They offer the inverse' return on an index. When the index falls, the ETF rises, and vice versa. Leveraged ETFs offer to give you twice, or even three times, the return on a given index.

So if the index rises by 5% in a day, you'd expect the ETF to rise by 15%. You can even get short leveraged' ETFs that offer, say, double the inverse return. So if the index falls by 5% in a day, the ETF would go up by 10%.

This sounds great, particularly if you're convinced a market is headed for a fall. But the problem is that these ETFs are rebalanced daily. That means that if you hold them for more than a day, they start to drift away from the performance of the underlying index.

Say an index rises by 10% over one day, from 100 to 110. A two-times leveraged ETF based on the index would rise by 20%, from 100 to 120. On day two, the index falls by 5%, from 110 to 104.5. The double-leveraged ETF falls by 10%. That takes the ETF from 120 to 108. So after two days, the index has risen from 100 to 104.5. That's a gain of 4.5%.

You might expect the double-leveraged ETF to have risen by 9%. But it hasn't. It's gone from 100 to 108, which is a gain of 8%. That's after just two days. Think of the potential drift after a month. The more leverage an ETF uses, the worse the drift. But even simple short ETFs will drift over time. These products might be useful for some short-term traders, but they aren't for beginners.