Defaqto

So what are ETFs?

ETFs are shares that are traded on a stock exchange and whose assets mirror the price movements of the underlying share portfolio of an index, sector or commodity, such as the FTSE 100, water sector shares, or gold.

In the UK, ETFs are traded on the London Stock Exchange, most of which are ETFs managed by Barclays Global Investors (BGI) which has a stable of 52 ‘iShares.’

In the European markets, there are roughly half a dozen issuers of ETFs which can be traded on Euronext Paris, Euronext Amsterdam, SWX Swiss Exchange, Frankfurt, Borsa Italiana and Virt-X.

In 2006, the European ETF sector grew by 50 per cent to almost £50bn, and is now growing more quickly than the well established US ETF market, which is worth in excess of $600bn.

What indices can ETFs replicate?

ETFS can replicate a very wide range of indices - investing in everything from shares and property, to more esoteric asset classes such as private equity, energy, commodities, infrastructure, property and water.

For instance, the Water iShare, which tracks the S&P Global Water index, provides exposure to 50 companies around the world involved in water-related businesses.

So what is the difference between an ETF and an index tracker fund?

These two investment vehicles are similar in that they both aim to mirror an underlying index, but the difference is that an ETF is a share which can be traded at any time of the trading day, whereas an index tracker fund is a unit trust which can only be traded at one point in the trading day.

There are also differences in charges. Because an ETF is a share, rather than a fund, you only have to pay a stockbroker’s commission and significantly, no stamp duty, whereas with an index tracker fund, you pay both initial and annual management charges, as well as stamp duty being charged within the fund itself.

Both unit trusts and ETFs are open-ended funds which means they do not suffer from the problem of investment trusts, which can trade at a discount to the value of their underlying assets.

This means that the price you pay to buy or sell at ETF is close to the value of the underlying assets of the share.

Can I invest in ETFs via an ISA, Child Trust Fund or pension?

Yes, you can place an ETF within any of these tax free ‘wrappers,’ providing you can find a stockbroker which sells ETFs and has its own ISA, Sipp or Child Trust Fund.

For instance, Alliance Trust Savings allows investors to invest in a number of ETFs via its Self Select ISA, and Sipp, using the Alliance Trust Savings’ share dealing service.

Who invests in ETFs?

To date, it has tended to be institutional and professional investors who have traded in ETFs because they offer real time pricing, which allows the investor to buy and sell the shares rapidly.

But as more ETF providers enter the market and ETFs become better known among private investors, ETFs are expected to grow rapidly in popularity with ordinary investors.

Where can I buy ETFs?

ETFs can be bought via most major stockbrokers such as The Share Centre and Redmayne Bentley or via the stock dealing service offered by some investment companies such as Alliance Trust.  By using an online share dealing service, you can buy an ETF for as little as £10 per share, irrespective of the size of the deal.

What are the charges?

The charges on an ETF can be even lower than those associated with index tracker funds. The annual total expense ratio (TER) for a an equity-based ETF is typically around 0.4 per cent pa which can be slightly lower than the annual charges on some unit trust tracker funds which typically charge 0.3- 0.80 per cent.

That said, Fidelity and Virgin have tracker funds which cost as little as 0.3 per cent pa. Legal & General, which is the largest UK provider of index tracking funds, has an annual management charge (AMC) of 0.5 per cent for its UK Index fund, and 0.75 per cent for overseas trackers.

A good fee-based IFA will often rebate their ongoing commission of 0.25 per cent bring the annual management charge down to 0.25 per cent and 0.50 per cent respectively.

Investing in a tracker fund via, say, a Fidelity or Virgin ISA, could work out cheaper than buying an ETF and placing it in a stockbroker’s ISA, as you will have to pay the associated costs of the stockbroker’s ISA on top, whereas with Fidelity and Virgin, the ISA ‘wrapper’ is thrown in for free.

There is no stamp duty on ETFs traded on the London Stock Exchange because they are registered in Dublin.

What are the other advantages of ETFs?

ETFs come into their own when it comes to accessing more exotic markets such as the Taiwan stockmarket or the Global Clean Energy index.

ETFs can also be traded in real time, instead of only once a day as is the case with a tracker fund.

Are there any tax differences between ETFs and index trackers?

There is no tax difference between holding, say, a FTSE 100 index tracker and a FTSE 100 iShare within a Pep, ISA or Sipp. Both will be free of capital gains tax and both will pay income tax with a 10 per cent tax deduction, which cannot be reclaimed.

Regular savings

A number of ETFs offer regular savings plans which may suit cautious investors who wish to hedge risk through pound-cost averaging.

By saving regularly, your investments each month may (if you are lucky) benefit from buying on the ‘dips.’ If this happens and the share price subsequently rises, you will do well. But there is no guarantee that this will happen.