ETFs: A great tool for DIY investors

Exchange-traded funds (ETFs) are cheaper than unit trusts and look set to become even more popular in the wake of the RDR, says Matthew Partridge

Many of those who manage their own money have already cottoned on to the benefits of exchange-traded funds ETFs account for an estimated $1.14trn of global assets under management. But as a result of the RDR, we expect to see financial advisers recommending low-cost products far more often, which means you can expect to hear even more about ETFs in the months ahead. So what are they and why do we like them?

ETFs are in effect unit trusts that are listed and traded on a stock exchange. They offer a cheap, easy way to track anything from share prices and indices, to commodities, currencies and bonds. They offer two main advantages.

Firstly, most are passive' investments: they simply track an underlying index or asset price, rather than trying to beat it. This means you don't need a fund manager to actively run the portfolio, which saves money. For instance, the iShares FTSE 100 ETF has a total expense ratio of 0.4%, compared to the 1%-1.5% charged by most funds. Given that few fund managers beat the market consistently, it seems silly to pay up for active management unless you are absolutely convinced by the fund manager's talents and investment views.

Secondly, ETFs are convenient. Say you want to invest in the Brazilian stockmarket. You could open an account with a local stockbroker, and wrestle with the paper work and expense that would involve. Or you could simply log on to your normal broking account and buy a London-listed ETF tracking the Brazilian stockmarket. This takes care of most of your diversification worries by spreading your money over an index.

Know what you are buying

So ETFs are cheap and convenient: two great reasons to like them. But like any financial product, you must ensure you understand what you're buying before you invest.

For a start, what does the underlying index track? Does it meet your needs? For example, say you want to invest in Africa's burgeoning growth story. There are several Africa' ETFs, but many focus heavily on global mining companies and South African stocks. That's fine if that's what you want to invest in, but it's not much use if you're in fact more interested in frontier markets, such as Nigeria, and the growing power of the African consumer. So ensure you look at the holdings that underpin the ETF. (Of course, you should do this with any fund you buy, active or passive.)

This isn't just limited to emerging markets, incidentally. For example, the FTSE 100 is Britain's benchmark index. Yet around 70% of earnings for companies in the index come from overseas. So it's hardly a bet on the UK economy. Similarly, if you want to invest in a US recovery, you should bear in mind that half the sales of S&P 500 companies (the main index in the US), and two-thirds of their profits, come from outside America. So think about what you're trying to achieve first, then make sure you invest in the correct product.

Also, be wary of more complex ETFs. For example, it's possible to buy ETFs that allow you to short' an index (ie, profit when prices fall). You can also buy leveraged' ETFs that give you double or even treble the return on a given index. These can be very tempting, promising large returns in a short period of time. But they are more suitable for short-term traders than for long-term investors. Because of the way they are built, anyone holding them for a longer period of time might find their performance diverges quickly from the underlying asset, particularly in a volatile market.

Similarly, commodity and currency ETFs allow you to take a position on the price of individual commodities, or exchange rates. But again, these are not for long-term investors. Costs can mount up quickly due to the nature of the underlying contracts. None of this should put you off ETFs plain vanilla' ETFs are good value and at least as transparent as a typical unit trust, and even the more complex products have their uses. The point is and this goes for any investment if you don't understand exactly what you're buying, then don't buy it until and unless you do.

'Physical' versus 'synthetic' ETFs

It's always worth checking whether your ETF uses physical' or synthetic' replication. This is a little technical, but it boils down to which method the ETF uses to track its underlying index. A physical' ETF owns the underlying asset (such as gold bars), or copies an index by owning the shares within it. A synthetic' ETF instead uses a derivative contract called a swap'. A third party agrees to deliver the ETF a return based on the index it wants to track. This can be a cheaper, more accurate way to track an index. But it introduces counter-party' risk: if the third party goes bust, you might not get the return you expect. While the chances of a default should be low, and the funds are also supposed to be backed (collateralised') by a basket of unrelated assets (so you'd get your money back at least), we'd favour physical ETFs, all else being equal.