EXCHANGE Traded Funds have certainly become a more mainstream investment product in recent years.
History should teach us, however, that, as with all financial products, you should understand the potential disadvantages of ETFs before parting with your cash.
ETFs are effectively investment funds that trade like shares so can be bought or sold in real time throughout the trading day, thus providing instant access to the required market. Like shares, they are not free to buy. A fee or commission is charged on purchases or sales.
The similarities with ordinary shares do not end there and this is where some investors come unstuck. Trading at either end of a business day could mean falling victim of the potentially wide spreads between buying and selling prices. These spreads could completely wipe out any advantage of not paying stamp duty, or the generally lower running costs of ETFs when compared with traditional retail unit trusts.
This is further complicated by the fact that ETFs investing in overseas equity markets, such as the S&P 500 index in the US will not be priced in real-time until after the New York Stock Exchange opens for business at 2.30pm GMT.
Not all ETFs are built the same. “Physical” ETFs use cash to buy the actual underlying securities that make up an index. Some buy only a representative sample of the securities in the index. Sampling can save on costs, but may lead to the ETF not tracking the index as closely.
Other ETFs, classed as “synthetic”, attempt to replicate an index by using “swaps”. This introduces an additional “counterparty” risk because the “swaps” are generally made with an investment bank, and I doubt you will need to be reminded what happened to some of those recently.
Assembling a “do-it-yourself” portfolio of ETFs carries all the same risks as using more established products such as unit trusts or investment trusts. The fact you might pay slightly less in fees will be of little consolation to you if you have lost a large portion of your capital because you bought the wrong ETFs. If you seek advice from any reputable adviser you should also be told about institutional share classes of tracker funds, some of which are available for 0.15% a year: half the cost of similar ETFs.
Barry O’Neill is a chartered financial planner with Thomson Shepherd and can be contacted on 01224 619215