A beginner's guide to ETFs

Exchange traded funds (ETFs) are becoming increasingly popular as investors seek products that they can trade quickly and cheaply. ETFs aim to replicate a fund structure, but - unlike unit trusts and open-ended investment companies - trade on an exchange.

"They look like a fund but trade like a share," says Hector McNeil, co-founder of Boost ETP. "They are very democratic. They allow any investor access to usually difficult-to-trade-on markets, currencies or asset classes at wholesale prices."

The basics

There are two main types of ETF: physical and synthetic. Both aim to track a chosen stockmarket index as closely as possible, but they take different routes.

Physical ETFs track an index such as the S&P 500, providing exposure to all the shares within the index (full replication), or to an optimised sample of those shares (partial replication). The latter is used, for example, for larger indices such as the MSCI World or MSCI Emerging Markets, where it would cost too much to own every share in the index.

The alternative would be to buy shares in a selection of the companies listed in the index to try and create your own replica of that market. But McNeil says it is not an attractive substitute: first, it exposes the individual to a lot of specific company risk, and secondly, it will be a far more expensive exercise.

Synthetic ETFs, conversely, do not physically hold the shares in which they invest. Instead they use swaps and derivatives to replicate the performance of the market. The swap is a promise from a counterparty, typically an investment bank, to replicate index performance.

The name "synthetic" has put investors off in the past and Phil Reid, UK head of external distribution at HSBC, says physical ETFs are seen as "the most vanilla way to track a bench".

However, the war between the two product types has largely subsided now, with investors more focused on cost and tracking error than the form that the replication takes.

Things to be aware of

It may be tempting to go for the cheapest offering, but that is not always the best option, warns McNeil. He points to various factors he thinks investors should take into account.

Liquidity is a prime consideration and higher trading volumes for a specific ETF will show that people are easily buying into and out of it, which McNeil says should be a good thing.

The issuer is obviously something to look at; an investor should be asking who the organisation is and what it stands for, as well as deciding if they would prefer to invest with a large institution, a private bank or a boutique firm.

Next, have a look at the company website. It should provide educational materials, transparent details of the ETF and its holdings, and a clear outline of fees.

Lastly, McNeil says the tracking error (the extent to which the ETF deviates from the index) of the fund is hugely important. "It is a good indicator of any additional fees. An ETF might cost just 50 basis points; but if it consistently has a large tracking error, that suggests there are more costs than they're telling you about."

Another consideration is whether to buy synthetic or physical funds. ETFs were originally constructed as physical funds, but some experts feel they have constraints. The transactional costs of buying a large number of shares are a concern, considering the product is designed to be as low-cost as possible, and tracking error could be a problem too.

Synthetic ETFs were seen as the remedy to this. The swap means the tracking error can be avoided, as the return is guaranteed to match the market (minus fees, of course). The advent of synthetic trackers has also made it easier to track more illiquid or obscure markets, such as bond indices.

To make a choice, investors need to look at the different counterparty risks in each case. For physical ETFs this means asking if the issuer is owned by a bank, and what would happen if the parent company went bankrupt. For synthetic ETFs it means considering the quality and diversification of the assets and the collateral policy of the issuer, as well as whether the issuer is independent of the swap provider.