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a Successful Stocks & Shares ISA

The solution to cutting investment costs: Use ETFs
Slowly but surely, more investors are waking up to the attractions of Exchange Traded Funds (ETFs) - a cheap and effective way of obtaining exposure to stockmarkets or alternative asset classes such as bonds or commodities.

Exchange Traded Funds are similar to open-ended mutual funds, which trade as single shares on stock exchanges and allow you to track the performance of a specified index or a sector. For example -

  • FTSE 100 ETF (ticker ISF) - tracks the FTSE 100 index
  • FTSE Dividend Plus (IUKD) - tracks a portfolio of high paying dividend stocks
  • Xinhua China 25 - (FXC) - tracks the Chinese stockmarket
ETFs don't just offer exposure to stockmarkets, they can be used to invest in commodities and bonds, as well as UK/global property. Ultimately ETFs offer the ISA investor easy, quick and cheap access to many different markets with the convenience of an ordinary share transaction.
How ETFs work
The investor owns shares in the ETF which in turn owns the underlying shares in an index. The ETF shares issued to investors mirror the underlying portfolio of shares in the constituents of the index. So if you buy the FTSE 100 ETF what you're really buying is every share within the index in their relevant weightings (mega companies like Vodafone have a higher weighting in the index than a smaller one like Rolls Royce).

Because ETFs are quoted and can be bought and sold throughout the day the price will be determined by the value of the underlying shares the fund holds, just like a basket of real shares in your portfolio.

An ETF's price will reflect the movement of these shares which is why you will not have wide discounts or premiums as can happen with Investment Trusts. It is important to remember however that no ETF will ever perfectly mimic an index because of the costs involved in running the fund but these costs are small, normally well under 0.5% per annum.

Two main advantages of ETFs
1. Costs & Charges

The main advantage of ETFs is that their annual management charges are considerably cheaper than those levied by actively managed funds. ETFs charge between 0.15% to 0.75% per annum while actively managed funds in the UK average 1.75%.

While such percentage annual savings might not initially seem such a big deal these are just the kinds of savings which should make them extremely attractive to ISA investors. Obviously a 1% saving in any given year is not remarkable, but the key as I mentioned before is that when 1% or more is saved over a multi year period on the total value of a portfolio and these savings are reinvested into the market the difference in performance can be remarkable.

2. Tracking A Market's Performance

Many readers will no doubt have spotted that if ETFs do nothing other than track an index then it's impossible for them to outperform the market. This is in contrast to actively managed funds where any one of them can theoretically return say 30%, even if the overall stockmarket rises by only 15% on the year.

But this fabled potential out-performance is the carrot that's always being dangled in front of investors. Many people believe they can beat the market with their stock or fund picks, and the marketing departments of the money management firms all promote the fact that their funds will be the ones to achieve it.

However for most, indeed for 90%+ of all market participants, the carrot will normally always remain out of reach. Remember, I am referring to the long term here, over a period of 5-10+ years and not in any given year, where of course it is possible to beat the stockmarket averages.

Personally I think for the majority of market participants the odds are around 50-1 against outperforming the general stockmarket over a 5-10 year period. Don't take it personally, but do think about it logically.

If the majority of professional investors can't achieve this and most of them are well educated, highly trained, extremely knowledgeable, experienced, have access to the best computers/technology, and work 40-60 hours a week at the game - it's got to be even tougher for the part-time investor.

Also, realise the consequences of attempting to do try and out-perform - it can lead to gross underperformance as perhaps you're in cash (expecting the markets to move sharply lower) but they rise 20% in 6 months

Some might think this is a defeatist attitude but it's not because the main point to understand here is that you don't need superior investment returns to generate great returns over many years.

6% - 7% is fine as long as you regularly -

  • Add funds to your portfolio
  • Reduce charges down to a minimum, and
  • Let compounding over the years take care of the rest

That in essence is the foundation of this investment strategy.

Tracking the market is also an efficient use of your time
Another reason to think about constructing an ISA investment portfolio out of ETFs and in turn be happy to match a market's performance is, it's an extremely efficient use of time.

Yes, of course it is possible to become a good stock picker/market timer but how many hours will this analysis take per day and week? Surely it can't be as easy as reading the Sunday Times Personal Finance section and subscribing to the Investors Chronicle?

No doubt both those will have some excellent ideas, but they will always be diluted with plenty of duff advice as well. So in many ways the art of successful stock/fund picking is as much about -

  • Sorting the small amount of wheat (good information)
  • From the massive amount of chaff (duff information)

Also, it's important to realise that however hard one works there's no guarantee the work will pay dividends.

Spend 5 years researching the markets for example and it's possible to lose money when investing in the 6th year. Conversely, someone who takes 5 seconds to flip a coin (heads = buy : tails = stay in cash) might produce excellent results for the year.

Note: There is a difference between a 'Tracker Fund' and an ETF
Confusingly a Tracker Fund offered by the big Fund Management firms is not the same as an ETF tracker, although both financial products try to achieve the same goal - to track the performance of an underlying index coupled with low management costs.

The main difference is that a Tracker Fund offered by say Fidelity or Virgin Money isn't traded like a share on an official Stock Exchange. So to buy or sell investors have to go through a more complicated procedure, such as only being able to buy or sell at a set price at a certain time of day. This is not the case with ETFs and therefore they are far more flexible.

Also, I really don't like the way many of these fund management firms charge for their Tracker Funds, they're open to playing too many games. Look at these statistics -

  • From 2001 - 2006 the best performing tracker fund delivered a 28% return, and the worst 15%
  • For the 10 years, 1996 - 2006 the best tracker made 117%, and the worst 74%

How is it possible for tracker funds that are supposed to mimic the performance of the FTSE 100 to generate such wildly different returns?

As ever it's all down to the shameless charging of fees. Can you believe that some of these tracker funds charge total annual fees of 0.3% while others levy nearly 2%! Quite frankly anything above 0.50% is obscene for a FTSE Tracker Fund and it proves that many firms are preying on the naivety of their clients.

Which ETFs to use

ETFs are organised and listed by the investment banks. iShares (which used to be owned by Barclays Bank) is one such firm and is the original ETF distributor and manager here in the UK.

  • An ETF manager deals with all the necessary listing, legal work and marketing of the fund
  • They're also responsible for the day-to-day management (stocks have to be bought and sold) as well as dividend payments
  • They get paid via the annual management charge
I prefer to use iShares as the majority of their ETFs are both simple and have excellent liquidity. Never discount the roll that liquidity plays (how many shares are traded on a given day) in keeping costs down. Put simply, liquidity means a tight bid-offer spread.
ETF - Frequently Asked Questions

Q: How can I buy ETFs?

ETFs are stocks so you would buy £1,000 worth of an ETF in a similar fashion to buying £1,000 worth of Vodafone. Call your stockbroker (or do the deal online), ask for a quote and then buy or sell, the transaction would normally be done in under 20 seconds.

Because they are traded like stocks the price of an ETF will always be moving. So as with any other stock it's possible to buy at the present market price or perhaps enter a limit buy order to purchase if the ETF price moves lower. Limit sell orders can also be placed to sell if the price moves higher.

Q: What are the costs of buying or selling an ETF?

Again, an ETF is a stock so your commissions will be exactly the same as if you're buying a stock like BT or Glaxo.

Remember that because ETFs are domiciled in Ireland but traded in the UK there is NO Stamp Duty levied of 0.5%. If you use TD Waterhouse, my personal broker of choice commissions are £12.50 per trade.

Q: What are the management costs of an ETF?

The annual management charges for UK ETFs range from 0.15% to 0.75%.

The cheaper management charges relate primarily to the UK, Euro and US ETFs, while the ETFs that invest in Far Eastern markets charge towards the upper end of the scale. Whatever the case ETF charges are considerably lower than the average for traditional UK funds which come in at an average of 1.75% per annum.

Q: How is the annual management charge levied?

Most ETFs will pay out dividends in the form of cash with the management charges being deducted from these payments. Dividends can be paid out quarterly, bi-annually or annually, depending on the ETF in question.

Q: What currencies are foreign ETFs traded in?

Any ETF listed on the London Stock Exchange is priced in pounds and pence even if the ETF in question is investing in Brazil or Turkey.

ETF Summary

I think you will agree that ETFs are easy products to understand, just think of them as shares that track an underlying index and have very low annual management charges.

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