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Investing in Equities with ETFs

VIDEO: Exchange-traded funds' instant diversification and low-cost benefits make them great tools for investing in equities

Holly Cook 21 February, 2013 | 6:00AM

This video is part of Morningstar.co.uk's Equity Investing Week.

Holly Cook: For Morningstar, I'm Holly Cook and I'm joined today by Al Kellett, an ETF analyst here at Morningstar. We're going to talk about how ETFs are useful tools for investing in equities. Al, thanks very much for joining me. 

Al Kellett: My pleasure. 

Cook: So, if we start off at first with, what is it about ETFs and other exchange-traded products that make them a useful tool for investors wanting to invest in equities? 

Kellett: Well, I think if you compare ETFs, for example, versus individual stocks, what you get is instant diversification. So instead of having the sort of unique, idiosyncratic risk associated with one company if you buy that stock, you might have exposure to 100 different stocks with an ETF, for example. 

Cook: And cost as well, that's something we always mention when we talk about ETFs? 

Kellett: Yeah, and particularly, when measured against traditional actively-managed funds, exchange-traded funds tend to have total expense ratios which are often in the realm of 20 to 50 basis points, which is considerably lower than what you would find in other funds. 

Cook: So a couple of the key benefits were that diversification and also the low cost, but are there any particular risks associated with ETFs versus perhaps the more traditional funds? 

Kellett: I think a key risk that you do find with many ETFs is something called counterparty risk. So in synthetic ETFs, which are close to half the market here for European ETFs, what you have is the fund enters a swap with a counterparty in order to get the exposure. And that counterparty will promise to make the payments, but if anything goes wrong with the counterparty, that's a risk for investors. 

With physical ETFs, where the fund is actually buying the underlying securities, the fund may then turn around and lend them out in order to get a fee and that also has counterparty risk in the sense of when you lend something out, there is the risk that you never get it back. 

Cook: So we know that investors can use ETFs to invest in a huge range of equities or even to kind of splice the market quite specifically—dividend-

paying equities, for example. But what should an investor really be looking for when they are doing their research, when they are trying to find ETFs that are suitable for them? 

Kellett: I think as you suggested the main thing is trying to decide what that underlying exposure should be, that's sort of your major decision. Once you've made that decision and you're trying to choose from amongst various products, you'd want to look at the cost, so the total expense ratio, and compare that fund to fund. You'd want to make sure there was sort of a critical mass of assets under management in an ETF. And then beyond that, you'd want to look at the structure, so if it's a synthetic ETF, is there collateral in place to mitigate that counterparty risk that we talked about; similarly, in a physical fund that lends out securities, is the collateral in place. 

Cook: So we know that ETFs are becoming increasingly popular in Europe and we're big fans of them here at Morningstar, but there are some sort of quite complicated products that some investors might find difficult to understand. I assume our recommendation would be, don't invest in anything that you don't understand. 

Kellett: Yeah. There can be place for a certain complex products, but I tend to think that if you can't explain it to someone over a cup of coffee, then it's probably not a great investment for you. So there is nothing wrong for an investor sticking to core offerings and building a portfolio of building blocks. 

Cook: Great. Well, thanks very much for explaining that to us, Al. 

Kellett: Thanks, Holly. 

Cook: For Morningstar, I'm Holly Cook. Thanks for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Holly Cook

Holly Cook  is Managing Editor of Morningstar.co.uk