Financial adviser and investment expert James Norton explains all about Exchange Traded Funds.

Regular readers of this website will be aware by now that at Evolve Financial Planning we are passionate supporters of index funds. They reduce the cost of investment and therefore help maximise returns. When we construct a client portfolio, once we have agreed the risk and asset allocation with a client, we then look at which index funds we can buy most cost-effectively, with the lowest tracking error.

Our decisions depend on which platform (wrap platform or fund supermarket), if any we are using and whether the investments are held directly or in PEP, ISA, pension or investment bond wrappers.

As a result of this, many clients may hold Exchange Traded Funds (ETFs) somewhere in their portfolio. As these are a relatively recent addition to the financial landscape it is not surprising that we are often asked what they are! The purpose of this article is to clear up the mystery.

In simple terms, ETFs are just another form of tracker fund in that they aim to replicate the growth and income of a selected index. Like investment trusts they trade on the stockmarket and can therefore be bought and sold any time the London Stock Exchange is open.

Like unit trusts, ETFs have an open ended structure, meaning that they can issue or cancel shares to meet supply and demand. This is important because it means that unlike investment trusts they will not trade at a significant discount or premium to net asset value, hence reducing the risk.

Like many innovations in financial services, ETFs first came to the market in the US. It was not until 2000 that they appeared in the UK when they were introduced by Barclays Global Investors, under the brand name iShares. They got off to a slow start in the UK mainly due to lack of understanding, but also due to the poor initial range of funds.

The market has moved on considerably since then. There are now 48 iShares trading on the London Stock Exchange tracking a diverse range of indices from the FTSE 100, to the Sterling Corporate Bond market as well as many overseas exchanges.

Recent additions to the range have included much more “exotic” indices such as the Macquarie Global Infrastructure 100 index and the S&P Global Water Index. Last year, a company called ETF Securities listed 29 ETFs on the London market, covering all the major world commodities.

So what do all of these developments mean for private clients?

The first point to note is that any increase in the choice of index funds available is good news. Compared to the US, the UK is light years behind, not just with the development of ETFs, but in the use of index funds generally. iShares have certainly helped push the debate on the benefits of indexing, and it is interesting to see a number of discretionary managers now using them as a core part of their portfolios to help keep overall costs down.

So, whilst in theory ETFs are good news, it is not as simple as that. Compared to many of the index funds we can access for clients, ETFs are still on the expensive side. For most major stock markets we can access funds where the charges range from 0.2% to 0.3% per annum. This compares to funds such as the FTSE 100 or S&P 500 ETF where the charge is 0.4%. This is still dramatically below the cost of an active fund which we highly commend, but it does mean that we often have better alternatives.

Choice

The other key issue is one of choice and which of the current range of ETFs are suitable for private investors. In the fixed interest arena there are some highly cost effective ETFs managed by iShares which only charge 0.2% per annum. However, on the equity side, there appears to be a plethora of esoteric markets such as the Korean, Taiwan or Turkish indexes (all of which charge about 0.75%).

As we said before, we welcome the increase in choice, but this is not necessarily helpful for investors. Choice encourages more active trading in and out of funds to catch the latest “hot” sector, and this increases cost. All of the evidence supports the fact that it is impossible to time markets and pick those sectors that are going to outperform in the future. This can be simply demonstrated by the following figures in a Financial Times article on 19th November 2006.

In 2000 when the US and indeed most global stockmarkets were about to enter their biggest decline for a generation, $259.5 billion entered the mutual fund industry. In 2002, when the market had suffered most of its falls, and was considerably better value, there was a net outflow of $24.7 billion.

So what relevance you may ask has this to do with an article on ETFs? Well, the figures help demonstrate that the private investors (as well as institutions) are very poor at reading the market. What is also interesting about this is that a huge amount of the money that flooded into the market in 2000 entered a specialist area – technology. Take it as a warning not to be tempted by some of the more glamorous funds investing in exotic markets. You are more likely than not to be buying near the top. Could Russia be a case in point?

We strongly welcome the emergence and growth of ETFs and will continue to use them to track mainstream indices, not fashion fads.

About the Author: James Norton (pictured) ACA, FSI, APFS, CFP, is a Director at Evolve Financial Planning. Evolve Financial Planning are winners of the Scottish Widows Award for IFA newcomer 2006, and are writing a series of articles exclusively for FinanceDaily.co.uk on the subject of investing. Visit www.evolvefp.com.

Do you have experience of Exchange Traded Funds? Do you think they are a good investment vehicle? Share your thoughts using the Comment on this Article box below.

The Archive

The Benefits of Index Funds: Users of index funds are often accused by active managers of missing out on huge potential returns, but James Norton of has yet to come across anyone who can persuade him otherwise.

Your Investment Portfolio: Fixed Interest: Gilts, corporate bonds and other fixed interest investments are often overlooked as 'boring' when it comes to building an investment portfolio, but, as James Norton argues, sensible investing is not about excitement.

Investing: Active versus Tracker Funds: The second article in our series on investing looks at the argument of active versus tracker funds and highlights evidence which suggests that most fund managers - so called stock choosing experts - invariably make the wrong stock selection choices.

Why Invest?: Financial planner and former stock-broker, James Norton, sets out how you can construct highly efficient, cost effective portfolios which should outperform many highly active managers.