Exchange traded funds (ETFs) have flourished into a market worth billions, offering hundreds of choices since they first became available to private investors. But most of those investors are based in the US. In the UK some investors harbour suspicions about the product's security and usefulness. Are investors right to be nervous or is there really nothing to be worried about?
Myth 1: ETFs are riskier than funds and shares
ETFs have been branded as riskier than active funds such as unit trusts, open-ended investment companies (Oeics) and even investment trusts, and according to some, are less suitable for private investors than the latter funds. However, many of the risks associated with ETFs are also present in actively managed funds.
Some physical ETFs lend the shares they hold to increase their revenues. This is also a common practice among open-ended funds, so if you hold pension funds, investment trusts or unit trusts/Oeics, they too may be lending securities, thereby exposing you to risk.
Current UK legislation does not require retail fund managers to disclose the risks of stock lending in their investor marketing materials or to lend less than 100 per cent of their assets. They are not required to publish daily individual fund stock lending exposures, the names of the largest borrowers or the precise make-up of the collateral backing these loans, whereas many ETF providers now disclose their stock lending practices.
Active funds can also use derivatives and some absolute return funds have very complex underlying structures and investment strategies similar to hedge funds.
Myth 2: ETFs are only for short-term trading
ETFs are good as core holdings because they are a cheap way to get exposure to major indices such as the FTSE 100, and can be used as building blocks to make up a portfolio. For long-term investors there is a great advantage in using ETFs because the typically lower costs of these funds eat less into your returns, which over time can stack up to substantial amounts if a fund's fees are high.
Given that ETFs now cover such a wide range of asset classes and regions, you could consider constructing an entire portfolio of ETFs, although if you do this it is important to get your asset allocation to different geographies and sectors right.
A good strategy can be to construct your portfolio using a mixture of ETFs and active funds. You could invest in core mature developed markets using ETFs, in particular in efficient markets such as the US where many fund managers fail to outperform, while in less efficient markets such as emerging and frontier markets, and even continental Europe, use a good active manager to add value.
Alternatively, you could use active funds for your core holdings and ETFs for smaller allocations to more unusual asset classes and markets, as you may not be able to access some of these with active funds. Examples include commodities, while more esoteric markets tend to be covered by a wider range of ETFs than active funds. Also, active funds which cover unusual markets sometimes have very high TERs.
However, more exotic assets are an area to be careful in when using ETFs. ETFs that track these areas may have a complicated underlying structure - for example, they may use synthetic replication, and in the case of commodities, offer exposure to derivatives such as futures rather than the spot price. This can result in the ETF underperforming the spot price. So it is very important you ensure you understand these funds and their structures before you buy them.
Myth 4: ETFs are always cheaper than funds and investment trusts
This is not always true, even though ETFs are marketed as cheap. You have to shop around and get beneath the bonnet of competitor funds to find the investments that are genuinely the cheapest. Peter Sleep, ETF specialist at Seven Investment Management, says that in general index tracking funds are cheaper than ETFs. And he warns buying and selling ETFs through the online platforms or brokers can be quite expensive for small or regular savers, so even if you do find a cheap ETF, the dealing costs could outweigh the low TER and make an index tracking fund more attractive - you need to watch out for this.
If you are only investing for the short term, minimising dealing fees and the bid-offer spread is more important than the annual charge as both of these costs will eat into your returns. Also be aware that the lowest cost ETFs may replicate the index synthetically. Synthetically replicated funds are complicated investment instruments that use derivatives to replicate the market. Often, they are more accurate than physical funds (which invest directly) but they come with a set of different risks, which you need to understand (see Myth 6).
Generally, ETFs are cheap investments but some have a number of hidden costs that can eat into your returns. For example, funds tracking foreign indices have to pay withholding tax, which is equivalent to 30 per cent of the dividend. This is something that has to be claimed back manually by signing a form, but some ETFs assume this form has not been signed and build this into their benchmarks. Also watch out for index, custodian, account and swap fees, which are not included in the TER. Look for the 'total cost of ownership' figure, which will give you a more realistic idea of the costs than the TER.
Myth 5: ETFs are the same as ETCs
They are not the same and there are a number of differences that set them apart.
ETFs are funds that are listed and traded on a stock exchange, just like shares. They are designed to track, as closely as possible, the performance of an underlying benchmark index. These are normally equity or fixed income indices such as the FTSE 100 or the FTSE UK Gilts All Stocks index, for example. But others track pools of assets based on a set of pre-decided criteria. ETFs are covered by the protective umbrella of European investment standards - Ucits - which means they are diversified, own physical assets, and have auditors.
Exchange traded commodities (ETCs) on the other hand, may or may not have the Ucits safeguards, and aren't always diversified as they usually invest in just one commodity - as a result, they can be very volatile. Like ETFs, ETCs are also listed and traded on a stock exchange, but instead of indices, they track commodities, such as metals, natural energy resources, or agricultural goods. In most cases, ETCs directly track the performance of a commodity, but sometimes this is not possible and the tracking of the value of the physical commodity is trickier. In this instance, ETCs track an index that measures the commodity's value instead.
Myth 6: Physical ETFs do not incur any of the risks of synthetic ETFs
ETFs fall into two main types: physical and synthetic. Physical ETFs buy some or all of the assets in the index they track. Synthetic ETFs do not buy the assets but get the return of the index they track via a swap counterparty, usually an investment bank or insurance company, which pays the ETF the returns of the index it is tracking, often in exchange for the returns of a collateral basket held by the ETF.
The advantage of doing this is that it can be cheaper to set up a swap than buy all the shares in an index, and regularly rebalance the ETF’s portfolio as securities move in and out of the index. It can also avoid certain costs, for example, physical ETFs holding UK shares are subject to 0.5 per cent stamp duty on the value of physical underlying securities when creating new units, while swap-based ETFs are not. However, the total expense ratios (TERs) of synthetic ETFs may not include transaction costs such as swaps.
A synthetic structure also works well when trying to replicate an index where it can be difficult to buy and sell the securities - for example, some emerging markets.
Synthetic ETFs can track better because the index return is guaranteed by the swap counterparty so they do not incur errors caused by inexact replication like physical ETFs, which do not always buy every share in the index.
The major risk with synthetic ETFs is that the swap counterparty defaults, say, because it has become insolvent and is not able to honour its obligation. But in recent years synthetic ETF providers have taken a number of steps to mitigate this risk.
Some ETF providers such as ETF Securities, iShares and Source use multiple swap counterparties on their synthetic ETFs so if one fails then there are others to fall back on.
If a synthetic ETF is compliant with fund legislation known as Ucits (Undertakings for Collective Investment in Transferable Securities), then it is obliged to hold collateral worth at least 90 per cent of the value of its assets to mitigate losses. In recent years, many providers of synthetic ETFs have taken a number of additional safeguards - for example, holding collateral worth 100 per cent or more than the value of the assets. However, if the benchmark index’s return is higher than the return of the substitute basket over a specific time period covered by the swap, investors are exposed to risk for that difference should the issuer not honour its commitment to the fund. Some synthetic Ucits-compliant ETFs both over-collateralise and have multiple swap counterparties.
Just as one of the main risks with synthetic ETFs is their exposure to a counterparty, so physical ETFs can also be exposed to risk. That’s because some of them lend the securities they hold as a way to boost revenues, which can help their returns and reduce costs for investors. The main risk with this is that the borrower does not return the assets, say, because it has become insolvent, so the ETF typically holds assets worth the value of the securities it has lent out.
This means that both physical ETFs that stock lend and synthetic ETFs ultimately rely on this basket of collateral. And while physical ETFs start off with a portfolio that includes the same or a nearly similar set of securities as the index they track, they can end up holding a basket of securities different from the index that is being replicated - not unlike a synthetic ETF.
An exchange traded note (ETN), meanwhile, is a senior, unsecured debt security which at maturity promises to pay the full value of the index it tracks minus the management fee. But unlike an ETF it generally does not hold collateral, so if the note issuer fails investors are at risk of losing their entire investment, making them subject to the credit risk of the issuer.
When you buy a Ucits ETF you have the reassurance that the investment exposure, and how that exposure is delivered to you, is highly regulated. Ucits also require ETFs’ fund managers to, among other things, entrust the assets of the fund to an independent depositary whose role is to safeguard the assets and ensure that applicable law and fund rules are respected; and to constrain the fund's investment policies in terms of eligible assets, minimum diversification, leverage and risk.
But non-Ucits ETFs offer access to assets that Ucits funds are not permitted to invest in - for example, certain commodities, and areas that private investors could not access otherwise.
Myth 7: Physical ETFs buy all the holdings in the index they track
Although physical ETFs buy assets rather than get their returns via a swap counterparty, they do not necessarily buy all of the assets in the indices they track. For example, certain bond fund ETFs tracking indices which contain thousands of bonds may only hold a few hundred bonds, as well as some securities not included in the index to help make up the returns of the index if they provide similar performance and have a matching risk profile to certain securities that make up the benchmark.
This sampling method is known as optimisation. Optimisation reduces trading costs and volatility, resulting in closer tracking of the index, and its track record is testament to the success of this approach. Buying all the securities in an index could incur tremendous trading costs so that the ETFs could not have low charges, while more esoteric securities can also be harder to buy and sell, meaning it might not be so easy or cheap for the ETFs to get hold of these, or sell them when necessary.
But because optimising funds are not the same as the index there is a risk that their returns will not track those of the benchmark. ETFs don't usually exactly replicate the returns of the indices they track because of their costs, so they usually underperform by a little. But optimisation adds another potential reason for a physical ETF not to track accurately.
Synthetic ETFs, which get their returns via a swap, have been criticised for holding collateral that does not resemble the index they track. However, an optimised ETF with only a small sample of securities in a given index, and perhaps some that are not in the index, is also different to its index.
If a particular security is difficult to buy - for example, in an emerging market where access may be difficult for foreign investors - a physical ETF may own some sort of proxy such as an American Depository Receipt (ADR) rather than the actual stock. This means the index could significantly outperform the ETF, as happened to the iShares MSCI Emerging Markets ETF over 2009. It returned 81.97 per cent, against 85.29 per cent for the index. The ETF was also held back in rising markets by holding cash during certain parts of the year to pay dividends.
Myth 9: ETFs are only good for tracking (beta) and not much use in creating Alpha
ETFs are associated with passive index tracking but providers are increasingly launching what they call smart beta ETFs. Rather than tracking a mainstream index such as the FTSE 100, they track indices constructed to have a special focus - for example yield, or to minimise risk.
Examples of such ETFs include ones based on minimum volatility indices, which seek to offer reduced volatility compared with standard market capitalisation weighted indices; funds that track bond indices put together on the basis of countries' gross domestic product (GDP) rather than the bonds issued; or enhanced commodity ETFs which try to track spot prices more accurately.
Smart-beta ETFs are still different to active funds as they aim to track rather than outperform an index and they tend to have lower costs than active funds. Smart beta ETFs can also offer greater transparency than active funds as they allow you to check what the funds are holding on a daily basis, and as they are listed shares you should be able to sell them quickly if you want to, which may not be as easy with a traditional active fund.
But it is important to look at the methodology of the underlying index and whether it is constructed according to a set of rules rather than a manager taking a subjective view. In the case of the latter, it might not be clear what you are taking on and the more active you get, the more risk of underperformance.
Also, creating a product that would have worked in past market conditions may not do as well when circumstances change.
Myth 10: One ETF performs much the same as another
There is some truth in this if you are taking a short-term bet on the markets. But if you build a long-term investment portfolio it is not necessarily true at all. ETFs covering the same region often don't have exactly the same holdings - and they perform in different ways as a result. Performance is one of the most important things you need to monitor with ETFs - and many brokers will have facilities that show you how different products are doing, which can help you make your decision if you're considering an investment.
It is worth checking exactly what you are buying as small differences in costs compound over time and rip large chunks out of your returns. Things you should look out for include whether the fund has UK reporting status, whether it is individual savings account (Isa) or self-invested personal pension (Sipp) eligible - and you should also have a look at the difference between the various indices and how closely the ETF tracks them. Fund fees are critical for checking how well an ETF is tracking its index. And see if you can get hold of tracking error and tracking difference data.
Tracking error measures how much the difference in the index performance and the fund performance fluctuates over time. However, tracking error measurements can have no bearing on actual investor experience. For example, if an ETF missed its mark by 0.05 per cent day in, day out, the tracking error would be zero. But if that index had stayed flat for a year you would have lost out by 12 per cent. What most investors care about is long-term buy-and-hold returns, and for these investors tracking difference is the measure to watch. Tracking difference looks at the overall difference between the ETF's performance and the performance of the index that it aims to replicate over a particular period - and the smaller this is, the better. But don't rely on the factsheet for this information - get stuck into the annual report instead.
