ETFs: A rather good ideaPosted by Alexander Hay
As our financial wizard, Peter McGahan, reveals, Exchange Traded Funds (ETFs) might be a good way of maximising your investments.
We all have our investments - pension funds, mortgage repayment vehicles, ISAs and so on. Each of these is invested into an investment fund which is a spread across a range of assets like stocks and shares, property and cash. Typically, those funds are either an insurance company's managed fund (a large, expensive, under-performing bag of mist), or a range of investments such as unit trusts or investment trusts, which may also be expensive or under-performers depending on what's been chosen for you.
Each of these funds has a fund manager - the star player who will (one hopes), be able to make great decisions for you. Good luck with that one! Hypothetically, these funds will perform, or not, based on the ability of the manager to maximise the returns, but in reality, it's an elite group of managers who are consistent enough to add value on a year by year basis.
Managers charge for the comfort of you knowing they are 'managing' the assets. And they charge well: With 5.25% initial fees along with annual fees in excess of 2% being the norm. Furthermore, if you buy some of these through a pension or life insurance bond product, there could be an extra layer of fees on top. I have seen product fees of close to 11% in some life insurance investment bonds!
Meanwhile, Exchange Traded Funds, or ETFs, have been slow to get going in the UK, perhaps because they don’t pay commission. However, their advantages are simple:
Firstly they are much cheaper. You might reasonably expect an annual charge (described as a total expense ratio) of over 2% for most unit trusts, while the average investment trust hovers around 1.75%.
An ETF's total expense ratio is closer to 0.2% with the far eastern ETFs topping the expense tree at 0.7%. You might not then necessarily expect to pay an ingoing fee, thereby saving the 5.25%. Also, unlike buying shares, most ETFs are not penalised by stamp duty.
An ETF is also simple in its construction. Unlike an investment fund where the manager makes all the choices of whether or not to be in the market, which stocks to buy and sell, and which to take gains on, an ETF simply tracks an index. An index is an example of the average performance of a stock market. The FTSE100 is an example of that. There are a range of global indices and an ETF tracks each of these in one of two ways.
The first is called full replication and that is where the ETF buys all the stocks that appear in that index. For example, a fully replicated FTSE 100 ETF will hold all the 102 stocks in the FTSE100 and have the appropriate weighting according to the FTSE100.
The other solution is to use sampling. This is where a computer is used to design the portfolio and track the index closely but not exactly. The ETF might decide to leave out less liquid stocks from its portfolio. (These are not easy to buy or sell, and might have a large difference between the buy and sell price, meaning extra charges for you.) The difference between the two should be reasonably minimal. For example, one ETF using the sampling method held 352 stocks as opposed to the index which had 360.
There are no real burning disadvantages to an ETF, other than the two obvious ones: Firstly, dividend reinvestment - some ETFs hold dividends in cash, and only pay them out to investors on a periodic basis. However, some ETFs have the ability to re-invest dividends daily. A lag in dividend re-investment may cause a small amount of under-performance in rising markets.
Secondly, you will receive no investment management and, as such,you won't have the ability the star managers have in a falling or sideways market. That is, to move in and out of the market and trade on ups and downs. A market that rises and falls constantly will bring opportunities that a simulated index will not be able to take advantage of.
Need Expert Advice?
Peter McGahan is an Independent Financial Adviser and Managing Director of Worldwide Financial Planning. Worldwide has won 16 Financial Times awards in the last four years. Peter has also been named the top media IFA of the year by Unbiased.co.uk in 2009.
Worldwide Financial Planning Ltd are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'
Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.
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