Exchange Traded Funds (ETFs)
In our previous article on mutual funds, we mentioned mutual funds and exchange traded funds (ETFs,) offer investors the ability to instantly diversify their portfolio. These fund types are collections of other securities such as stocks, bonds, and other commodities investors own together in a pool. Each fund contains dozens or hundreds of other assets. While mutual funds have been around for quite some time, ETFs have only been available since the early 1990’s in the US and since the new millennium in the UK market. There are other fairly large differences between the two and these contrasts can potentially make a major impact on your portfolio. I’ll address these differences and cover ETFs in great detail in this article.
Contents
ETF and Mutual Fund Differences
One of the most important distinctions between an exchange traded fund and a mutual fund is the management of the fund’s securities. As we explained in our previous article, mutual funds are actively managed, meaning that assets within the fund may be traded on a day to day basis. ETFs on the other hand, are not generally actively managed. Instead, they are a set pool of securities that are often (but not always) established in order to mimic the movements of certain indexes, or industries within an index, such as the FTSE 100, the Dow Jones, or the NASDAQ.
ETF Fees and Expenses
As a result of the lack of active management, ETFs tend to have lower expenses than their fund counterparts. Expense ratios are almost always below 1% per annum, while mutual fund expenses generally run between 1% and 3%. In fact, an ETF earning lower annual growth can still be a better long term investment than some mutual funds that feature high gains but also have more expenses.
For instance, a £1000 mutual fund with 7% annual growth and a 2% annual expense fee will net you £1048.60 after the first year, while an ETF with 6% growth but only 1% in expenses per annum will net you £1049.40, even though one would think they would both net 5%. This is a difference of only 80p, however, over time this difference will only multiply. After five years the difference is £4.84 and after ten years it grows to £12.30. It is also multiplied through larger investments.
ETFs do not have a load, or sales charge, like some mutual funds do. Instead, they are traded like other securities and may have a trading charge, depending on your account or your stockbroker. The charge will be just as if you were trading shares of stock instead of an ETF, since they are traded over an exchange just like stocks. For this reason, some opponents of ETFs argue that they are more expensive than mutual funds. This very well may be true for small orders through an expensive broker. However, these prices can be kept in check by purchasing in larger quantities or through discount brokers. For example, a £100 ETF purchase through a broker who charges £10 per trade will result in a 10% trading charge. However, a £1000 purchase on the same ETF with the same broker will only entail a 1% trade charge since the fee is the same. So really, the sales fees depend on a number of factors, but you can and should shop around for the best price when planning an ETF purchase.
As we mentioned, ETFs are traded on an exchange, just like stock, hence exchange traded funds. This makes them very liquid assets, since they can be bought or sold at any time when the exchange is open. Mutual funds may only be bought or sold at the end of the day, when the NAV (net asset value) is calculated. The liquidity of the ETF market helps keep the spread close, meaning the difference between the buying price and selling price is minimal, so ETFs are not expensive in that sense.
UK ETFs
Although ETFs have only been available for trade on the London Stock Exchange since spring of the year 2000, they have grown in popularity exponentially each year. The number of ETFs available has exploded at a rate of more than 75% in recent years as more and more investors realize the benefits of cost effective ETF trading.
One of the most well-known among the many ETF market makers is iShares, which is run by the asset management company BlackRock. iShares have a very wide array of ETFs from which to choose and include sectors such as Developed Equity, Emerging Equity, Fixed Income, Commodities and more. Further, by choosing a sector, you can narrow your search even more by selecting from specific countries, regions, markets or indexes in which you would like to invest. ETFs even allow for trading in precious metals like gold or silver and there are variations of ETFs that only invest in eco-friendly companies and other very small sub-sectors of the market as well.
More ETF Features
Individual investors may purchase an ETF from a broker in a number of different accounts. ETFs may be owned inside an ISA or a SIPP as well as a regular trading account. When inside an ISA or SIPP, exchange traded funds are treated like other investments for tax purposes. That means that outside of an ISA, the owner is responsible for any capital gains tax, when applicable. ETFs do not generate capital gains as often as mutual funds, though, since capital gains are only generated upon sale of a security, and securities that make up an ETF are not frequently traded.
When researching ETFs to find a solid investment, it is best to stick to larger, frequently traded ETFs, especially while gaining experience. Small or lesser known ETFs are not traded as frequently and may experience some liquidity issues (although rare). Among the most traded ETFs are the S&P 500 SPDR also known as the Spider (symbol: SPY), the iShares Russell 2000 Index (symbol: IWM), the iShares FTSE 100 (symbol: ISF), and the PowerShares QQQ (symbol: QQQ, tracks the NASDAQ-100 Index). Any of these exchange traded funds would be a solid investment for those with a long-term horizon.
Although ETFs are regularly traded over exchanges around the world, they are not meant to be short-term investments. That’s not to say that people do not make money with ETFs trading them over short timelines, but they were really designed for long-term, buy and hold type investors. Short-term trading will negate some of the low-fee benefits of ETFs since trading expenses will add up quickly. However, whatever your strategy, exchange traded funds offer great options for hedging a portfolio, capital appreciation, regular income or simply saving for retirement.