ETFs – Elements 5

ETFs

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This post is part of the Elements series, a Periodic Table of all the Investing Elements that you need to take control of your financial life. You can find the rest of the posts here.

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ETFs

What is it?

ETFs are Exchange Traded Funds. Together with Exchange Traded Commodities (ETCs) they form the group of assets known as Exchange Traded Products (ETPs).

The simplest way to think of them is as index funds that are listed on the stock exchange.

They are passive instruments than aim to track the performance of an underlying index (the target, or benchmark), but they can be traded like a normal share.

This gives them advantages, and certain risks, that are not present on traditional index funds (OEICs).1

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What kind of element is it?

An ETF is a financial asset – it’s something that you own, usually inside a wrapper such as an ISA or a SIPP.

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Who needs it?

Everybody needs ETFs – they are usually the lowest cost and most flexible way to access a wide variety of asset classes.

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What comes before it?

Strictly speaking, you need nothing other than a stock trading account with a broker in order to buy an ETF.

But in practice, you need several other things first – you need a budget and a plan, and some financial statements to show how far along with your plan you have got.

Your plan will include an asset allocation – a description of which assets you want to hold, which in turn will depend on your risk tolerance (another part of your plan).

And you need a tax-shelter – a wrapper to hold the ETF inside. This will normally be a SIPP or an ISA.

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What comes after it?

If you hold it in an ISA, nothing – you just sell the ETF when you need the cash, and take it out of your ISA.

If you hold it in a SIPP (a form of pension), you need to put the SIPP into Drawdown before you can access the cash. This in turn means that you need to be 55 years old.

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What age do you need it from?

As soon as you start saving, so ideally no later than 25.

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What age do you need it until?

For the rest of your life. You will be living off your ETFs in retirement (decumulation).

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How much does it cost?

Costs vary widely, both in terms of the ETFs themselves and the wrappers. We’ll focus here on the ETFs.

The platform you choose for your ISA and your SIPP may restrict the range of ETFs that are available. Before choosing your platform, you need to check which ETFS are supported, and how much they will cost.

The better platforms will include a “Core” range of six to twelve ETFs that are relatively cheap (0.07% to 0.25% pa). The drawback will be that only six to twelve asset classes will be covered.

For many people this will not be a problem. For those who want exposure to long-term potential growth across all asset classes, additional – higher-cost – ETFs will need to be added.

See also:  State Pension - Elements 16

This is unlikely to push the cost of the portfolio above say 0.5% pa.

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What’s in it?

There are two kinds of ETF – physical and synthetic (also known as derivative-based).

Physical ETFs hold the assets from the index they are tracking. This is very safe, but also expensive, as they need to buy and sell assets as their prices change (which in turn changes the composition of the index).

There are two kinds of physical ETF – those that use full replication (holding all the constituents of the index) and those that use “optimised” replication (holding only a sub-set of the constituents). The latter are usually cheaper, but may not track the index quite as well.

Synthetic ETFs hold a basket of quality assets (usually blue-chip stocks from the local main market, such as the London Stock Exchange) and use a “swap” contract with a bank to transform the returns from this basket into the returns of the index that the ETF tracks.

This is usually cheaper than a physical ETF, but introduces counterparty risk. If the bank providing the swap contract fails, then instead of the returns from the desired index, you might end up with the returns from the clue-chip stocks.

There was a lot of talk about the risks of synthetic ETFs a few years ago, but most of this was overblown. There’s very little risk that you will lose your money if a counterparty goes bust, and there are mechanisms in place to ensure that the gap between the desired returns and the blue-chip returns remains small.

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What does a good one look like?

A good ETF has four main features:

  1. it comes from a reliable provider
  2. it’s big enough (in terms of assets / market capitalisation) to be liquid (easily and cheaply traded)
  3. it has low running costs (annual charges) for the asset class that it covers
  4. it has a track record of sticking close to its target index

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What does a bad one look like?

A bad ETF has the opposite four features:

  1. it comes from a new and unproven provider
  2. it’s small, so that it’s difficult and expensive to trade
  3. it has high charges for its asset class
  4. it has no track record, or a track record of drifting far from its index

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Any recommended brands?

The main ETF brands are iShares, Vanguard, SPDR, ETFS (for commodities), db (Deutsche Bank) and Invesco PowerShares.

Usually one of these six will have an ETF to suit your needs.

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What are the main risks?

We’ve covered the key risk of physical vs synthetic ETFs above, under “What’s in it?”

Apart from that, I would say that the main risk is not owning them.

The three things that private investors control that will have the greatest impact on their long-term returns are costs, taxes and asset allocation.

ETFs tick all the boxes:

  • they are usually the cheapest way to access an asset class
  • they are compatible with the key UK tax wrappers (SIPPs and ISAs)
  • they allow you to access a wide variety of asset classes

After that, the next risk is choosing bad ones rather than good ones.

See also:  Insurance - Elements 18

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How do you deal with these risks?

Researching ETFs is pretty easy. Your platform will have a lot of information on the ETFs that they offer, and in addition you can use websites like Morningstar.

You need to make your own decision on whether you are comfortable with synthetic ETFs (I am). This will determine the universe of ETFs that are available to you.

Then you need to look at the four items we mentioned under “good vs bad”, above:

  • who is the provider, and what is their track record?
  • how big and easy to trade is the fund?
  • is it cheap?
  • does it have a good record of sticking close to the target index?
  1. Technically many ETFs qualify as OEICs in order to offer consumer protection, but most people understand OEICs to mean mutual funds / unit trusts that are not traded on exchanges []

Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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8 Responses

  1. Avatar John B says:

    It would be a good idea to explain the domicle/reporting status for ETFs, as that confused me when I first started. Get the wrong sort and your capital gains could be considered income, or you could be taxed at source by another country (as some US ETFs are) unnecessarily

  2. Avatar Martin says:

    Hi Mike, although they are cheap and can make overseas markets accessible, ETFs don’t pay any dividend income? Looking at the FTSE 100, it is at the same level as exactly 10 years ago. I’m not sure about other markets, but I would be looking to gain exposure to say China or Emerging Markets within my asset allocation. Although probably more expensive would I not be better off opting for Investment Trusts rather than ETFs? I would be interested to understand in what instances you would opt for an ETF over other instruments such as an Investment Trust.

    • Mike Rawson Mike Rawson says:

      Hi Martin,

      ETFS do pay dividends, based on the underlying investments.

      In an ideal world, I would be 50% passive (ETFs) and 50% active (25% investment trusts, 25% OEICs) for international stocks and non-equities. I would use individual stocks for UK equity exposure, since we have good information and cheap dealing for those.

      Unfortunately, there are no tax-sheltered accounts with capped charges for OEICs, so I am gradually moving away from them.

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ETFs – Elements 5

by Mike Rawson time to read: 4 min
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