ETFs: Should you believe the hype?

Exchange traded funds are one of the fastest-growing areas of investment, with millions of pounds having been ploughed into them over the past few years - but they are also one of the most over-hyped and misunderstood financial products.

Commonly known as ETFs, these funds are traded on stock exchanges in a similar way to quoted companies. They give investors cost-effective access to a wide variety of countries, asset classes and investment styles, providing a cheap way to track specific indices such as the FTSE 100.

Recently, however, a new breed of more complicated ETFs for more sophisticated investors has emerged, and these are proving more controversial.

While ETFs are generally very affordable, offer wide exposure to asset classes and indices, and are easy to value and trade, they are not always the perfect choice for investors, according to Justin Modray, founder of website Candid Money.

"ETFs are useful innovations that provide investors with lots of choice and flexibility, but you should always ensure you fully understand the index they're tracking and how the fund works," he says.

So what do you need to know about these products in order to judge whether they'll be a useful asset or a potentially high-risk addition to your portfolio?

ETFs are best defined as funds - similar to more traditional unit trusts or mutual funds - that are listed and traded on stock exchanges around the world, giving investors relatively easy access to a wide variety of investments on a real-time basis.

The main differences between an ETF and a straightforward unit trust are that ETFs are traded on a stockmarket, like any other listed stock, rather than being bought and sold through a fund manager or fund platform.

Most of these ETFs are 'passive' products. This is because the vast majority of them aim to replicate the performance of an underlying index rather than trying to outperform it - the aim of 'active' managers.

ETF transactions are subject to the same fees as share transactions but generally have lower management fees than unit trusts. They can also be traded at any time, which gives you much greater control in terms of timing.

Real versus synthetic

According to Manooj Mistry, UK head of db X-trackers, Deutsche Bank's ETF offering, the first task for a would-be investor is to grasp the difference between real or physical-based ETFs and the synthetic or swap-based versions.

"Although both types aim to achieve the same goal - tracking an index at low cost - they won't go about it in the same way, and it's important to understand the differences," he says.

First, a physical-backed ETF takes direct positions in either all or a representative sample of the securities that underpin the index being tracked. "A swap-backed ETF, in contrast, achieves its tracking by entering a swap agreement with an investment bank, which agrees to provide the ETF with the exact returns of the index," explains Mistry.

As swap-based ETFs rely on a counterparty to deliver the returns of the underlying index, this represents a degree of risk. However, under financial regulations, their maximum exposure to counterparty risk is limited to 10% - and they typically keep well below this level.

But regardless of which route you choose, you should be aware that there are potential downsides, as Modray warns.

"Not all ETFs come at bargain basement prices, and charges can sometimes be comparatively high for a tracker," he says. "As they are traded on the stockmarket, investors will also have to pay stockbroker dealing fees when buying and selling."

How can you hold ETFs?

ETFs can be used in a number of ways: either as a core part of your portfolio or as a satellite holding that provides concentrated, focused attention on particular sectors or regions.

Both will give you much-needed flexibility, according to Andy Gadd, head of research at Lighthouse Group.

"ETFs are a useful addition to the choices available," he says. "They have allowed investors to be far more precise in their asset allocation, both domestically and around the globe, and to achieve this in a very cost-effective manner."

Andrew Merricks, head of investments at Brighton-based Skerritt Consultants, agrees. "I have clients who buy into index-linked gilts instead of buying an ETF with them in," he says. "They allow you cheap access; why pay hefty annual management charges for asset classes that are fairly low-return products anyway?"

Pros and cons

Not everyone buys into these arguments, though. Patrick Connolly, spokesperson for AWD Chase de Vere, prefers to use tracker unit trusts to meet his passive investing needs; he doesn't agree with exposing clients to the more obscure areas that some ETFs cover.

He also points out that ETFs are not covered by the Financial Services Compensation Scheme (FSCS).

"With trackers, it's far easier to understand what is happening 'beneath the bonnet'," he argues. "Why would we use something more complicated that provides less investor protection?"

However, the benefits of ETFs, particularly the relatively low costs and trading flexibility involved, have helped fuel their staggering rise in popularity.

At the end of 2010 there were 2,459 ETFs across the globe with assets of $1,311.3 billion - compared with 1,943 ETFs and assets of $1,036.1 billion exactly a year earlier, according to a study by BlackRock. This represented a 26.6% increase in the number of ETFs, with 593 launches and 77 being delisted.

The biggest provider in Europe, in terms of both the number of products and assets under management, is iShares, with a 35.8% market share.

Too far too fast

However, some financial advisers express concern about the pace of development, with the introduction of more complicated types of ETFs making it difficult for people to select the right solutions.

Connolly says: "The number of launches is making the entire ETF market more confusing because they each take different approaches."

If you are a would-be ETF investor, you need to have a clear idea of which index or asset you wish to track and then find the funds that best meet those needs, both cost-wise and in the ways in which they operate.

You also need to steer clear of the more complicated ETFs unless you have a lot of confidence in your abilities as a trader.

How to get involved

You can access the market via a broker - and there are a number of choices.

For example, execution-only brokers will simply buy or sell according to your instructions, but won't give any investment or trading advice. Advisory brokers will provide assistance as well as helping to execute the trading decisions, while discretionary brokers will carry out the trades on your behalf and may have authority to make decisions without your prior approval.

Should you steer clear of inverse ETFs?

The downturn triggered a demand for ETFs that could work in different market conditions, and so more complicated ETFs using shorting (inverse ETFs) and leveraging techniques began to emerge.

Essentially, an inverse ETF works in the opposite way to a traditional ETF, in that the value of your holding will rise if the index it follows falls. This enables you to make a profit during the bad times.

Conversely, leveraged ETFs work best when you are confident that a particular index will soar in value. Very broadly speaking, depending on the structure of an individual leveraged ETF, you can enjoy two or three times the growth of an index.

According to Hector McNeil, managing partner of ETF Securities, these sorts of ETFs are used to implement short-term tactical views and hedging strategies that allow investors to gain in rising, falling and trending markets.

"People have been doing these sorts of trades within spread betting for a long time, so having these products, which are properly constructed and traded on an exchange, is an extremely powerful proposition," he says.

Unfortunately - as is often the case with these ETFs - it's not quite as simple as that in reality, and such products can cause problems, according to Farley Thomas, global head of wealth solutions and ETFs at HSBC: "They are very difficult to explain and understand, which means they create challenges for the adviser as well as the end-investors."

The design of these complicated ETFs is in stark contrast to the original ETF concept, which focused on simplicity.

"If the index goes up, the ETF normally does as well, so you pay for what you get," says Thomas. "Leveraged ETFs, however, are a bit more nuanced because if the index goes up today, you'll get the leverage return, but if it goes down tomorrow, you'll get the leveraged return of tomorrow."

Over time, this means although the index might be up 10%, your leveraged ETF may have fallen by a similar amount: it all depends on how the index performs on a daily basis. This means you need to make a fresh call on the product every day.

It also means that these sort of ETFs are not for everybody. "They are designed for the more sophisticated trader. However, ETFs are listed and available to the general public - and that's where the potential problems lie," Thomas adds.

Three ways you can use ETFs

To provide broad diversification: You can get exposure to a variety of markets quickly and easily.

To enable a core/satellite approach: You can use them to build core holdings in your portfolio or for 'satellite' exposure to certain areas.

For tactical short-term investing: ETFs' ability to trade whenever you want enables you to take advantage of market movements.