Exchange traded funds

What are ETFs?

ETFs are funds that are traded on a stock exchange and whose assets mirror the price movements of an underlying index. ETFs are available to track most indices, whether they are stock market-based or otherwise. For instance it is possible to purchase an ETF that will follow commodities (strictly called an ETC).

There are two different styles of ETF. The first is underpinned by the provider holding the physical assets, which means there is little counterparty risk. The second type relies on a counterparty underwriting the risk, and in this case there is some risk from counterparty failure, for example, Lehman Brothers in 2008.

One methodology is not necessarily better than the other but it is an issue that potential investors should be aware of. For this reason potential investors should seek the advice of an independent financial adviser or wealth manager before investing.

What is the difference between an ETF and an index tracker fund?

The difference is that an ETF is a fund which can be traded at any time of the trading day; whereas an index tracker fund is a mutual fund, which can only be traded at one or two points in the trading day.

There are also differences in charges. Because an ETF is stock market traded – rather than direct with the provider for funds – you only have to pay the stockbroker’s commission, and significantly, no stamp duty. With an index tracker fund, you pay both initial and annual management charges, as well as the stamp duty charged on trades made within the fund itself.

This does not necessarily mean the ETF is much cheaper, but this is often the case.

Both unit trusts and ETFs are open-ended funds, which means they do not suffer from the problem of investment trusts, which have a fixed number of shares in issue and therefore suffer (or gain) from the effects of supply and demand. In other words the shares of an investment trust can be valued at either a premium or discount to the value of the underlying assets.

Can I place ETFs in an ISA, child trust fund or pension?

Yes, you can place ETFs 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.

Be aware that one of the reasons why ETFs have failed to catch on in a big way with UK retail investors is that they do not pay commission to intermediaries, so they tend not to be mentioned by commission-based advisers.

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 in recent years, ETFs have become increasingly popular with ordinary investors.

Outside a tax free wrapper, capital gains from both ETFs and index tracking funds are taxed at 18%.