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Exchange Traded Funds (ETFs)

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Five-minute guide to exchange-traded funds

Exchange-traded funds (ETFs) are being promoted as a low-cost way of investing and have become more popular in recent years. But what are they all about and should you jump on the ETF bandwagon?

by Tom Bailey

Tom Bailey Column:  why I stick to passive in emerging markets.

Fund, investment trust and ETF data. See the latest »

1 December

What are synthetic ETFs and are they too risky?

Synthetic ETFs sound risky, but there are clear benefits to using them.

by Tom Bailey

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Commodity ETFs

To achieve a well-diversified portfolio, many investors decide to gain exposure to commodities. ETFs are one of the most popular ways to do this. 

There are several ways to gain commodity exposure with an ETF. An investor can choose to invest in an ETF that tracks a broad basket of commodities. An example of this is the iShares Diversified Commodity Swap UCITS ETF, which seeks to track the performance of an index of 20 commodities.

Alternatively, an investor may wish to gain exposure to a certain segment of the commodities market. For example, if an investor wanted exposure to metals, they could choose the iShares MSCI Global Metals & Mining Producers ETF, which tracks the performance of aluminium, steel, precious metals (such as gold and silver) and minerals.

Alternatively, an investor may want exposure to one specific commodity. For example, an investor may want exposure specifically to gold. This could be achieved with the iShares Physical Gold ETC.

Investing in commodities with an ETF, however, is slightly more complex due to the complicated nature of the commodity market. Unlike equities, investors cannot just buy physical commodities. Instead, commodities usually trade as futures contracts. These are agreements to buy a defined quantity of the commodity at an agreed price at an agreed date. So, ETFs tracking commodities often need to invest in futures contracts to gain exposure. 

Short ETFs

Short or inverse ETFs provide the opposite performance of what they are tracking. These ETF make use of derivatives and other methods to do that. So, an inverse FTSE 100 ETF will provide investors with a 5% return if the index falls by 5% during one days’ worth of trading. Likewise, if the FTSE 100 goes up by 5% in one day an inverse FTSE 100 ETF will lose 5%. 

These products are useful to investors who believe that the market or a commodity will fall in price, allowing them to go ‘short’.  

Historically investors gained short positions by borrowing shares from another investor and selling before the market declined. Those shares were then repurchased at a lower price when (or if) the market fell and returned to the original owner, allowing the investor to pocket the difference. This is a relatively laborious and costly process, particularly if the investor wants to go short the whole market or a large basket of equities. Short ETFs make this process much easier and smoother for investors.

The problem is that this is very risky. The general direction of the market, historically, is up. Going short an entire index, therefore, requires guessing correctly that the market will do something statistically it does not do (go down) most of the time. This requires extraordinary skilful timing on the part of the investor. 

This is less of an issue with commodities, the price of which often fluctuates more wildly. However, guessing which way oil or gold or some other commodity will go is hardly an easy task and many investors end up losing a lot of money trying to guess or predict such market declines. 

More sophisticated investors may opt for a short ETF to act as a hedge to the rest of their portfolio. For example, an investor could have exposure to several FTSE 100 stocks. To limit their losses if the market goes the other way, they may hold an inverse ETF. 

But it should be point out that most investors would be better served by simply having a well-diversified portfolio. 

Leveraged ETFs

Leveraged ETFs provide exaggerated returns compared to the market that they track, also using derivative contracts. 

For example, the WisdomTree Silver 2x Daily Leveraged ETC provides investors with a return twice the amount of the price of silver, as tracked by the Bloomberg Sub Silver index. This means that if the index rises by 5% in one day, the fund should go up by 10%. Conversely, if the index drops by 5%, the fund should fall by 10%.

These ETFs can track and provide leveraged exposure to various investment types, such as a specific commodity or market index, such as the FTSE 100.

Anyone buying such an ETF needs to be confident that the market will go the way they expect it to. These products substantially increase risk.  Even small market movements can cause a large loss (or gains). 

Investors can also opt for short leveraged ETFs. For example, the WisdomTree FTSE 100 3x Daily Short ETF. As the name suggests, it provides three times the opposite performance of the FTSE 100. 

As mentioned, going short is very risky as is using leveraged ETFs. 

A full list of interactive investor’s short and leveraged ETFs can be found here

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ETF stands for exchange-traded fund. Invented in the early 1990s, ETFs are investment funds that can be traded on stock exchanges in the same way equities are. ETFs started their life as ways to track a broad basket of stocks using an index, such as the S&P 500, Dow Jones Industrial Average or FTSE 100.

Primarily, this is what they are still used for. However, over the years ETFs have become more sophisticated. They now offer the ability to track a basket of a wide range of other asset classes such as bonds, property, currencies or commodities.

ETFs usually track a basket of stocks or other assets. To do this they track the performance of a specific index, most commonly available from companies such as FTSE or MSCI.  

ETFs will provide the return of an index, minus their management fee. 

There are two types of ETF structure: physical and synthetic. The difference is a physical ETF will actually hold an asset, while a synthetic ETF simply tracks the asset. The ETF issuer enters into a swap contract with a counterparty to provide a return equivalent to that from the underlying asset. With this comes what is known as counterparty risk. This is something to be mindful of as the company issuing the derivatives could go bust and therefore you might lose some of your money.

ETFs now come in all shapes and sizes. The simplest are those that track long-established equity indices. There are also those that track bond market indices, a basket of commodities, baskets of currencies and property.

In recent years ETFs have become more niche. Investors can now find ETFs that offer exposure to increasingly specific baskets of equities or other assets.

Other ETFs track certain sectors within a wider index. For example, many popular ETFs track such such as the banks and financials sector in the S&P 500.

Some ETFs track certain themes. For example, a popular theme in recent years has been cloud computing. A cloud computing ‘thematic’ ETF will usually track a cloud computing index, which will comprise companies deemed to be involved in cloud computing. 

Another ETF option is known as ‘smart beta’ in industry jargon. These ETFs do not track shares by market capitalisation, as a fund tracking, say, the FTSE 100 index would.

Instead, they actively decide which shares to track by targeting shares that possess certain characteristics. For example, some smart beta funds follow a basket of companies that are reliable dividend payers, while others target the highest-yielding shares on a particular index.

The primary advantage of ETFs is that they are low cost. Thanks to their unique structure and (usually) having no portfolio manager, they are much cheaper for investment houses to run. As a result, investors are charged less. Some popular ETFs charge as little as 0.05%, which works out at £5 on a £10,000 investment.  There is no stamp duty to pay when you buy an ETF. 

Another attraction is simplicity. Investors who buy an ETF opt to simply ‘buy the market’ and their returns will mirror how the index performs, minus fees.

Another key advantage of ETFs is that they offer access to previously hard to reach parts of the market for private investors. Prior to the invention of ETFs, investors would have struggled to find a way to gain exposure directly to the price of oil or be able to easily track a basket of value stocks. 

The main disadvantage is that an ETF will (in vast majority of cases) not outperform the index it is tracking. Actively managed funds, run by fund managers, aim to provide outperformance, but there are no guarantees this will be achieved. 

Beginner investors should consider using an ETF to gain exposure to major stock market indices. Broad exposure to main markets such as the S&P 500 or FTSE All Share is viewed as a sensible core part of any beginner investors portfolio. ETFs provide a cheap and easy way to do this. 

ETFs that hold dividend paying stocks pay those out to investors. 

Generally, ETFs pay out the dividends of the stocks they own on a quarterly basis.

ETF investors can receive the proceeds of their dividends in either cash or additional units in the ETF in question. Many investors chose to reinvest their dividends to increase their holdings, allowing their dividends to compound. 

ETFs are listed on the London Stock Exchange, so you buy them through a platform like interactive investor. This means you need to factor in dealing costs.

Exchange-Traded Products (ETPs) including ETFs, ETCs and ETNs track a wide variety of underlying investments, some of which may be complex in nature and involve leverage, shorting or a high degree of volatility. It is therefore important that you read the Prospectus or Fact Sheet (available on the issuers' websites) prior to investing and ensure that you understand how it is structured and the associated risks.

Tax laws may change. If you have any queries on taxation in relation to your investments please speak to a qualified tax adviser. Please remember, the value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest.