How To Save Money When Investing By Using Exchange Traded Funds (ETFs)

In last month's newsletter we discussed how to save money when investing by using some of the newer types of financial products. One of these new tools mentioned was Exchange Traded Funds or as they're commonly referred to, ETFs.

What Is An ETF

• Simply put it is a mix of stocks to create one stock, for example a simple ETF could buy shares in Vodafone, BT, Cable & Wireless, o2 and a few other major telecoms stocks. Put all these stocks together in a fund and then offer investors the ability to buy this as the one stock
• Other ETFs track indexes, so if you wanted exposure to the American S&P index the fund would buy all the stocks within the index (in their relevant weightings) and offer a simple way to buy into that market based in Sterling
• The ETF market in London is at present immature because investors (especially retail ones) have not realised the advantages they offer over the traditional way (expensive Investment Funds) of getting exposure to certain (mainly foreign) markets or sectors
• But in the US the ETF market is exploding in liquidity and there are literally hundreds of different ETFs to invest in

The Advantages Of ETFs over Investment Funds

The number one advantage is cost. Firstly they have no ludicrous 'load', a 'load' is common practice with investment funds where the fund management firm charges an average of around 5% for the privilege of investing in the fund. Invest £10,000 today in ABC fund and only £9,500 goes into the fund, £500 gets swiped by the manager on day one. Investment funds also charge around a 1.5% management charge.

But ETFs have NO load coupled with annual management charges of between 0.15% and 0.75%. We all know the power that compounding can have on a portfolio over a period of time so the initial 5% one can save immediately by investing in an ETF can make a serious difference to a long term holder and investor. This is especially the case if you're using say a SIPP as your investment vehicle and have a minimum 10 year outlook.

Further ETF advantages include -

• Because ETFs are stocks there is always a market so giving instant liquidity
• Theoretically they always trade at 'fair value' meaning they cannot trade at a discount to asset value, this is because the stock holdings of each ETF is published meaning that arbitrageurs will quickly act on any price anomalies
• ETFs can easily be shorted
• They pay quarterly or biannual dividends from which the management fees are subtracted
• Most UK ETFs are quoted in Sterling so the investor has no currency risk when investing in foreign markets
• UK ETFs are listed in Dublin but trade in London which means there's 0% Stamp Duty

Active Versus Passive Funds

Don't believe the marketing or what your IFA will tell you about active managers being better than passive ones.

An active manager is one who will pick the stocks in which to invest, whereas a passive fund will normally just buy either the main stocks in an index or all the stocks so as to mimic the index itself. Chances are your IFA is getting a kickback when he sells actively managed funds and nobody in the money management business likes passive funds because they don't levy a hefty up front load.

In effect, actively managed funds are great business for either the people running the funds or those promoting them because they end up with a cut of any business produced.

Of course, there are always exceptions to the rule. But investors must also not make the mistake of piling money into today's 'hot' fund manager, the ones who have got the best track record over the last year. Plenty of studies have shown this to be the worst way to pick funds.

The Current Problem With ETFs In The UK

As mentioned earlier the ETF market in the UK is not that well developed with only about 20 different ETFs available to investors. But expect this to change over the next few years with investors slowly catching on to their cost and flexibility advantages.

The main problem is therefore one of choice compared to what US investors are offered. Also, some of the UK ETFs are not that liquid so one should keep an eye on the difference between the bid-offer spread. However, extra costs due to a relatively wide bid-offer are not that relevant for long term investors.

Who Runs & Promotes An ETF

An ETF is operated and run by a financial firm. They do the necessary legal paperwork and regulatory business and then simply list the share on the stockmarket. iShares which is owned by Barclays Bank is the main promoter in the UK but ETFs are designed and operated by -

• Vanguard
• Powershares
• StreetTracks

With ETFs Your Portfolio Can Get Really Technical

ETFs can easily be shorted using Contracts for Difference (CFDs) which opens up all sorts of possibilities to the experienced trader or investor. For example, a portfolio can consist of a long UK/Short US corporate bond play, or an investor might be more bullish on UK shares than continental ones so could add this long/short trade to their portfolio.

• Not sure what 'shorting' is, or the ability to make money from falling prices - Read our simple guide

And as more ETFs are developed including sector ones like they have in the US then it will be easy to be long for example the retail sector, telecom sector and energy sector while short the computer and the drug sector. If you've got a SIPP these types of strategies can easily be traded within that account.

However, strategies and methods similar to this must only be considered by market participants that really know what they're doing alongside having plenty of experience.

List of The Main UK Exchange Traded Funds Operated By Barclays iShares