If you want better investment returns by maximising the cost efficiency of your individual savings account (Isa), exchange traded funds (ETFs) are worth some consideration. It's their low charges that will help you achieve better efficiency - they rarely have a total expense ratio (TER) above 1 per cent and can go as low as around 0.1 per cent - making them much less costly than the actively managed funds you may already hold in your Isa portfolio.
ETFs are traded on the stock market and can hold assets including stocks, commodities and bonds. Most track an index and can make attractive investments due to their low costs, tax efficiency and equity-like features. However, if you want to invest in ETFs through your Isa you may have to use a self-select Isa, a service offered by stockbrokers including Barclays Stockbrokers, Halifax Share Dealing and Selftrade. Only a handful of fund platforms offer ETFs: Alliance Trust Savings, Hargreaves Lansdown, Bestinvest, Nucleus, Fidelity, Sippdeal, Sippcentre and TD Direct are in the minority that do offer them.
Because ETFs are listed shares you have to buy them through a stockbroker, so every time you buy one you will incur trading charges. This can become costly if you make regular payments into your Isa rather than a lump sum once a year, so if you are going to do the former, you may be better off looking at other types of funds. This does not necessarily have to be an active fund - you could use a tracker such as those offered by Vanguard and HSBC.
Where do they fit into my portfolio?
An increasing number of investors are buying ETFs alongside actively managed funds in their Isas, but the construction of their portfolios varies greatly depending on investment objectives and risk appetite. Choose your funds according to your willingness to accept risk (and losses) and your investment timeframe. The longer your timeframe, generally the more risk you may be willing to tolerate.
There's no right or wrong number of ETFs to hold in your Isa, but you should only invest in as many as you have time to keep track of, or they could lose significant amounts of money right under your nose.
And if you're investing in ETFs for the first time, stick to vanilla products you understand and can keep track of easily. First time investors should play it safe by opting for very big funds and avoiding funds that offer inverse or leveraged returns if you want to avoid the nasty shock of large potential losses.
Most investors dipping their toes into ETFs will go for plain vanilla products such as ETFs that track the FTSE 100 index or S&P 500 index. Here are some suggestions for starter products that may not be so obvious to a beginner:
If your risk appetite is conservative take a look at PIMCO's Sterling Short Maturity Source ETF (QUID). It's a very short-term bond fund that seeks to maximise income while preserving capital. It's cheap with a TER of 0.35 per cent and the yield to maturity at present is 0.7 per cent. It seeks to provide a small return over cash, after fees, without the volatility of the equity markets, or the corporate bond markets. The focus on shorter-term bonds is important as it reduces the ETF's sensitivity to changes in interest rates, which will go up one day.
If you're looking for some moderate risk, advisers are keener than ever on emerging markets ETFs as a long-term play. SPDR Barclays Emerging Market Bond (EBND) could be a good pick as it diversifies away from sterling, which has been depreciating recently. Peter Sleep, ETF specialist at Seven Investment Management, says: "With this fund you can enjoy regular income and the possibility of gains from currency appreciation in the long term, but there are some risks as emerging market countries have a history of default."
If you want to inject a higher level of risk into your portfolio consider the Powershares FTSE RAFI All World 3000 fund (PSRW). It has a TER of 0.5 per cent and will give you a broad selection of stocks in both the developed market and the emerging markets, focusing on stocks it perceives as being inexpensive. Powershares invests in an index put together by FTSE and RAFI that focuses on companies' economics and disregards their stock market value, so it can find cheap stocks. This approach can lead to extra volatility but performs well over the long term.
And if you want to invest in a commodities fund, gold is your best bet according to analysts. ETF Securities Physical Gold fund (PHGP) is a top Investors Chronicle pick and has a TER of 0.39 per cent.
CHECK ISA ELIGIBILITY
Virtually all Ucits ETFs listed in the UK can be put into an Isa, but ETFs listed in the US are not eligible and certain exchange traded commodities (ETCs) listed in the UK are not eligible, either. This is because some of them are not funds, but loan notes, and are therefore not Ucits compliant. Undertakings for Collective Investment in Transferable Securities (UCITS) are a set of European Union directives which mean collective investment schemes can be marketed throughout the EU whilst maintaining high levels of investor protection.
Most ETFs listed in London are domiciled in Dublin or Luxembourg, which means they are classed as offshore funds, and some might not benefit from the tax advantages of an Isa. Check on the ETF provider's fact sheet and other literature to see if this is the case - if you cannot find the information, contact the provider to check before you invest. And if you do accidentally opt for an ETF that isn't eligible for Isas, platform and Isa managers will prevent the investment going through so you won't lose the tax benefits of your Isa.
Offshore funds also do not automatically have UK reporting status, which means that once you sell your shares or units in them you may incur income tax rather than capital gains tax, as you would when you sell a UK-domiciled fund. Many ETFs listed in London have share classes with UK reporting status, but again, ensure you check the provider's literature before you invest.
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