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Investing with exchange-traded funds

Exchange-traded funds (ETFs) offer investors a viable alternative to index tracking funds. Morningstar explains the pros and cons.

Morningstar.co.uk Editors 10 July, 2003 | 1:46PM
ETFs and index funds are similar in that they both mirror the performance of various sector and stockmarket indices such as the Dow Jones Industrial Average, the FTSE 100 or the S&P 500.

Yet an ETF is an investment product that combines the characteristics of open-ended funds and shares. It is – like a fund – a basket of bonds or shares. But it tends to act more like a share.

One advantage to investors is that ETFs are traded on a stock exchange and can be bought or sold throughout the day. Funds such as unit trusts or open-ended investment companies (OEICs) are only priced daily or less frequently. That means an investor who sells shares in a fund during the day must wait to find out what price he will receive.

Another advantage over funds is that the structure of ETFs prevents managers being forced to sell holdings to meet redemptions. Buyers and sellers are simply matched through the stockmarket. However, investors may run into problems with liquidity if investing in an ETF that tracks a thinly traded sector or stockmarket.

The annual management fee for an ETF tends to be much lower than for a fund. The fee varies from one ETF to another but it is generally less than 0.75% per year and often under 0.5%.

Because most ETFs are domiciled outside of the UK investors can usually avoid paying stamp duty when trading them. Investors can check with their brokers for ETF-specific guidelines.

Shop around

However, the cost of investing can add up. Because ETFs are bought and sold through stockbrokers investors must pay commission for every transaction.

These costs will hit investors who invest on a regular basis the hardest. That said, investors should shop around as brokers are often willing to negotiate different charging structures based on factors such as transaction size and trading frequency.

Investors can also hold ETFs through a tax efficient wrapper such as an Individual Savings Account (ISA). Because ETFs are bought through a broker rather than from a fund group the investor needs to use a self select ISA. Some brokers offer commission discounts for ETFs traded within an ISA wrapper.

Investing in ETFs can involve hazards. Currency risk can be a problem for investors. Even ETFs listed on the London Stock Exchange are not always denominated in sterling. Those listed in dollars or euros expose investors to the ups and downs of the foreign exchange markets which can both boost and hit returns.

The price of an ETF can move to a slight premium or discount to its net asset value but large block trading by institutions tends to keep it low.

The British market for ETFs is not as developed as that in America or continental Europe but is growing. Barclays Global Investors is currently the biggest provider of ETFs – which it calls iShares – to the UK market offering 13 share-based products and two bond ones. Merrill Lynch also has two products listed on the London Stock Exchange under the LDRS brand.

Neil Jamieson, the head of marketing at comdirect, a stockbroking firm, said: “There is a growing interest in the product but the market needs more issuers.

“A bit of competition from UK houses or even a US house would be good for the market and create awareness.”

[July 14th: The final sentence of the fifth paragraph has been rephrased].

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.

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Morningstar.co.uk Editors  analyse and report on shares, funds, market developments and good investing practice for individual investors and their advisers in the UK.