ETF Guide
What is an Exchange Traded Fund (ETF)?
ETFs are an easy way to gain exposure to a pool of investments without having to buy each one individually. They can track a stock market 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, or passive funds, in that they attempt to track the performance of a market index or pool of investments, unlike “active” funds which try to beat the index.
ETFs are also 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 When money is withdrawn units are redeemed.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, like all exchange traded products, are traded on a recognised stock exchange, such as the London Stock Exchange.
Why use an ETF?
Some of the key attractions of investing in ETFs are low cost, transparency, flexibility and choice. An ETF tracking a developed equity market such as the FTSE 100 can cost as little as 0.07%, compared to an average 1.01% for UK large-cap mutual funds (Morningstar, August 20) 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 and the capital required.
ETFs unlock diversification for investors because they typically follow broad based and well diversified indices, spreading the risk of your investments across many securities.
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 clients, 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 market index
It is always important to ask: would I like to invest in the components of this index? Indices are rules-based methodologies and 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, and whether it accurately reflects our investment team’s views.
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. In order to do this, we look at what is known as the tracking difference of each ETF – how closely the ETF manager has matched the performance of the index – and look to select 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 overall cost in each asset class. This includes the fund's total expense ratio (TER), a measure of the cost of running the fund and the managers’ fees which are charged to investors and taken from the daily value of the fund but critically also considers the fund's performance and the costs of trading. We seek to select the fund that delivers the most overall value for our clients.
4. Size and trading volume
Size and trading volume of an ETF are important considerations, and clearly, we do not want to invest large amounts in an ETF where trading volume is limited. We typically aim to use the ETF with the lowest bid-offer spreads – i.e. 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. We also seek to understand the liquidity dynamics for the underlying index holdings, in order to better understand the costs of ‘creating’ or ‘redeeming’ a given ETF.
5. The type of ETF
There are two main types of ETFs: 'physical', and 'synthetic' or 'swap-based'.
‘Physical’ ETFs aim to deliver the performance of an index by investing in its individual components.
The replication can be ‘full’, in which case the ETF provider will simply buy every component of the Index. This replication is typical for highly liquid indices such as the FTSE 100 or the S&P 500. The replication can also be ‘partial’, which involves replicating strategies such as ‘stratified sampling’ and ‘optimisation’, where a sample of the securities that mirrors the characteristics of the overall index is selected to closely track the index’s performance while reducing trading and operational costs. This replication is typical for less liquid indices.
‘Synthetic’ ETFs use a financial instrument called a 'swap' (a legal agreement between two parties, of which one is normally a bank, known as the counterparty, and the other is the ETF provider). Under the terms of the contract, the counterparty agrees to deliver the return of an index to the ETF fund in exchange for the return of a basket of securities. This basket is used not only to finance the swap agreement, but also as collateral or security to help provide protection if there is a credit event (the counterparty being unable to fulfil its obligations). While synthetic ETFs do carry a credit risk compared with physical ETFs, in recent years ETF providers have significantly improved the mechanism to protect themselves against credit events, such as selecting multiple high-quality counterparties to diversify credit risk.
In using ‘swap’ agreements to replicate an index, the ETF fund incurs lower administration and operational costs, better replication of specific assets and increased tax efficiency by removing the withholding tax impact on income received from dividends (withholding tax is a tax that is deducted at source – please note that tax rules depend on individual status and may change). By entering into a swap, the fund avoids holding the physical securities, completely avoiding the withholding tax impact. This often results in a lower TER (the fee the investor pays), as well as a significant reduction in taxation impact. As a result, this reduces the tracking error (the difference between the ETF and index performances), or even sees the ETF outperforming the index.
Nutmeg invests predominantly in physical ETFs, whilst also allocating to synthetic ETFs where the risk-reward is particularly attractive. This is especially the case for large US equities indices where dividends are subject to 30% withholding tax (for funds domiciled in Luxembourg) and 15% (for funds domiciled in Ireland).
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 “currency hedged” version of a fund to mitigate the risk.
Do we hold any actively managed or enhanced ETFs in our portfolios?
A passive investment strategy has potential benefits, including lower fees, greater transparency and tax efficiency. But where passive funds are designed to mimic a market index, the intention behind an actively managed ETF is to outperform a market index.
We actively choose a broad range of ETFs, assigning and re-assigning our clients’ 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 beta” ETFs, which track specially constructed indices. These are often constructed to deal with specific inadequacies or excessive bias in some markets. Commonly these indices weight holdings according to other fundamental factors (such as dividend payouts or other characteristics), rather than simply using market capitalisation as the weight, however they remain rules-based in their approach.
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.
All investments carry risks, and this is no different for ETFs. And while they may not be protected under the Financial Services Compensation Scheme, 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.
What types of ETFs are there?
We’ve included a few of the most popular ETF types below, but this is by no means an exhaustive list:
1. Broad-market ETFs
By far the most popular type of ETFs are those tracking a large part, if not all, of the stock market – and typically an equity index like the Russell 3000 or S&P500. In this instance, the underlying stocks are highly diversified and likely to encompass both household names and lesser-known companies from across a range of industries
2. Sector ETFs
A sector ETF tracks a particular industry, be it technology or healthcare, and typically states the name of the sector – or sub-sector – in its title. Investors may favour a sector ETF in order to benefit from the business cycle or to leverage one sector’s risk/reward characteristics. For example, technology may be prone to more volatility than a traditionally stable sector like utilities.
3. Smart Beta ETFs
Smart Beta ETFs are slightly different in that they follow a rules-based, systematic approach to choosing stocks from a particular index. These ETFs still track an index, while also considering alternative factors such as total earnings, profits, revenue, or financially driven fundamentals and metrics. This type of ETF is still relatively new and, as such, trading volumes and liquidity are generally lower than average.
What is the difference between an ETF and a mutual fund
The big idea behind ETFs was to give investors a tax-efficient and liquid product that was not a mutual fund. At their core, both ETFs and mutual funds are made up of money pooled by many investors, the premise being that individual investors have access to economies of scale and greater diversification they otherwise wouldn’t.
The most obvious difference to a mutual fund is that ETFs are exchange traded, so we can transact in the ETF throughout the day, rather than at one set point each day as in the case of a mutual fund tracker (typically around midday). This provides additional flexibility in managing portfolios and means whole units of the fund can be bought and sold between investors without needing to buy and sell the underlying holdings of the fund.
Flexibility is just one part of the equation. ETFs allow us to understand the exact price at which we will purchase or sell, before the transaction takes place. This is critical to efficiently managing portfolios, and to many investors’ surprise this is not the case with mutual funds. Because a mutual fund index tracker prices and trades once a day, you will typically not know the price at which you have bought or sold until after the transaction. ETFs, on the other hand, trade on recognised stock exchanges, meaning pricing visibility is high and they can be traded whenever the relevant stock market is open.
Similarly, ETFs offer daily transparency on their holdings, allowing us to better understand and model risk, whereas mutual funds typically offer investors this insight once a month (and often delayed).
Finally, the range of ETFs on offer is much broader than that of mutual funds. ETFs offer access to many assets that tracker funds do not, and in many other shapes and forms. This provides us with more tools with which we can implement our investment ideas, and allows a higher degree of risk control and granularity when managing portfolios.