ETF Guide

What is an Exchange Traded Fund (ETF)?

ETFs provide an easy way to gain exposure to a pool of investments without having to buy each one individually. They can track a share index, such as the FTSE 100, an asset class, such as government bonds, a market segment, such as bonds maturing in fewer than five years, a region or a sector. ETFs are referred to as “passive” investments, in that they attempt to track the performance of an index or pool of investments, unlike “active” funds which try to beat the index.

ETFs are known as “open-ended” investments/funds rather than “closed-ended”. This means that when money is invested in the fund, new shares (units) are created. When money is withdrawn units are redeemed. ETFs are traded on a recognised stock exchange, such as the London Stock Exchange.

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Why use an ETF?

The key attractions of investing in ETFs are low cost, transparency and daily dealing. An ETF tracking a developed equity market such as the FTSE 100 can cost as little as 0.1 per cent per year, compared to a typical cost of between 1.5 and 2 per cent for an actively managed fund. Unlike a unit trust, which trades at one set price point during the day, ETFs can be traded whenever the stock exchange is open. This makes them a flexible way of investing.

Investing in ETFs also makes it easier to diversify your portfolio. For example, buying an ETF that tracks the S&P500 is comparable to buying a small part, in the appropriate proportion, of each of the index’s 500 companies – all at a much lower cost than would be feasible for an individual given the commissions charged for each trade.

Similarly, a typical corporate bond ETF would contain more than 200 individual bonds, so the default risk is highly diversified.

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How do we select our ETFs?

For each asset class, region or market segment, we find what we consider to be the best ETF, while continuously monitoring the alternatives. As our aim is to provide a diverse set of opportunities for our customers we try to assess as many ETFs as possible. These are some of the most important factors that inform our thinking.

1. The components of the index

It is always important to ask: would I like to invest in the components of this index? Indices are normally constructed by weighting each underlying instrument according to its market capitalisation (size) in that particular market. As a result, some indices give a large weight to one particular company or country. By looking at the underlying components we can judge whether each index is, in our opinion, a suitable investment.

2. Method of replication and tracking error

The method for holding the physical components of an index varies from fund to fund. Many funds use a system of optimisation, whereby a sample of the holdings are used to replicate the index’s performance as a whole. We therefore look at what is known as the tracking difference of each ETF – how closely the ETF has matched the performance of the index – and choose funds which are as closely aligned as possible.

3. Costs

Subject to other factors listed here, we aim to hold the fund with the lowest Total Expense Ratio (TER) in each category. The TER includes the fees, such as the cost of running the fund and the managers’ fees, which are charged to investors and taken from the daily value of the fund.

4. Size and trading volume

We consider the size and trading volume of each ETF. Clearly we do not want to invest large amounts in an ETF where trading volume is limited. We also seek to use the ETF with the lowest bid-offer spreads – ie the smallest gap between the cost of buying and selling each fund. While a low TER may look attractive, if the bid-offer spread is very large and/or the fund size is very small, we would not necessarily use that fund until these conditions have improved.

5. The type of ETF

There are two main types of ETFs: “physical”; and “synthetic” or “swap-based”. At Nutmeg we invest only in physical ETFs, which aim to produce the performance of an index by investing in its individual components.

Synthetic ETFs, on the other hand, use a “swap” (a legal agreement between two parties, of which one is normally a bank) to produce the return, while holding the assets of the fund as collateral. Collateral can take the form of many instruments, and may be completely unrelated to the index the ETF is trying to replicate. In some instances – commonly in more esoteric markets – a synthetic ETF can have lower costs than a physical ETF, but we believe that investing in a physical ETF is safer as it is less exposed to what is known as counterparty risk: the chance that one party in the transaction may go bust. Moreover, the collateral held in the synthetic ETF can be of a poor quality, which is difficult to trade.

Similarly, we do not invest in “leveraged” or “short” ETFs. Leveraged ETFs attempt to use borrowing to provide a multiple of the performance of an index – for example, twice the monthly performance of the FTSE100. Short or “inverse” ETFs aim to produce the opposite – for example, if the FTSE 100 fell by 2 per cent, the short FTSE ETF would rise by 2 per cent. We believe that these sort of ETFs are more appropriate for day traders than long-term investors. When we believe markets are likely to fall, we can take other measures to protect portfolios, such as buying government bonds.

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Which currencies are ETFs traded in?

ETFs are commonly traded in Sterling, US Dollars and Euros. For non-UK indices (such as the S&P 500) the ETF is often traded in US Dollars and Sterling, giving investors a choice. However, while a Dollar-based ETF may also trade in Sterling, it is still at risk of currency fluctuations. We consider this currency risk when investing in an ETF and in certain circumstances may invest in a “hedged” version of a fund to mitigate the risk.

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Do we hold any actively managed or enhanced ETFs in our portfolios?

At Nutmeg we actively choose a broad universe of ETFs, assigning and re-assigning our customers’ money based on our rigorous analysis of the global economy. We will utilise active ETFs where we believe there is a strong rationale for doing, though allocations are unlikely to make up a large proportion of portfolios. Additionally, we do allocate to “smart” or “enhanced” ETFs, which track specially constructed indices. These are often constructed to deal with specific inadequacies or excessive bias in some indices. Commonly these indices weight holdings according to other fundamental factors (such as dividend payouts or country size), rather than simply using market capitalisation as the weight.

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What are the risks of ETFs?

One of the potential downsides of an ETF is that, because it does not always hold every asset in the index it is trying to replicate, there will be a slight difference between its performance and that of the index. Although this “tracking difference” can work in an investor’s favour, it can also work against them.

Although the majority of the ETFs we choose are traded in British pounds, those traded in a different currency can expose you to foreign exchange risk. The exchange rate fluctuations may affect the capital performance and income generated from these ETFs when converted to sterling.

ETFs are not protected under the Financial Services Compensation Scheme. However, in the very unlikely event that the ETF provider goes bust, you would still have access to the ETF assets, which are ring-fenced and held by a separate custodian.

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