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ETFs: Investment must-have or the emperor’s new clothes?

By Jane Wallace
Reading time: 6 minutes

Exchange-traded funds, or ETFs, have been trending for a while. Much like traditional tracker or passive funds, most ETFs simply track the ups and downs or a market index or a basket of assets; there’s no human fund manager picking the investments and possibly getting it wrong. Subsequently, it can be easier to understand where your money is invested (the fund does what it says on the tin) and costs can be lower.

Fashions come and go in the investment world, just like any other sector. Sometimes it’s a certain country or industry in vogue, other times a particular investment style or type.

Exchange-traded funds, or ETFs, have been trending for a while. Much like traditional tracker or passive funds, most ETFs simply track the ups and downs or a market index or a basket of assets; there’s no human fund manager picking the investments and possibly getting it wrong. Subsequently, it can be easier to understand where your money is invested (the fund does what it says on the tin) and costs can be lower.

Where the two types of fund differ is in structure. Investors in ETFs buy shares of the ETF, not units like a traditional fund. The geeky detail here is that, as the investor, you technically own a share of the ETF, not the underlying assets it tracks, whereas with a traditional fund (passive or active) you own shares of the underlying holdings. One of the benefits of ETFs is that you can deal at any time the stock exchange is open, allowing you instant exposure at a price in real time. Traditional funds, in contrast only deal once a day, so the value of the underlying assets might have changed (but usually not too much) since you put the deal on.

Because ETFs are cheap to set up, fund providers have flooded the market with mainstream and, increasingly, specialised styles. There are now ETFs dedicated to sectors and themes as diverse as space exploration, gender equality and even the shopping habits of Millennials. In fact, the popularity of ETFs may be behind the recent explosion in stock market indices: there are now 3.05 million indices, according to the Index Industry Association. That’s 70 times more than the amount of listed companies worldwide, which the World Bank says is only 43,342.

It’s a dazzling display, for sure. But what’s really going on underneath all the frills and thrills? There are a few naked truths about ETFs you should know before jumping in with both feet.

Naked truth 1: Cost

ETFs have a reputation for being inexpensive and are often marketed as such. However, some fees have crept up over the last few years due to increased marketing and licensing costs. Meanwhile, some traditional funds have been attempting to drive fees down. As a result, the lines have become more blurred between active and passive funds, including ETFs, as we discussed in this post.

Remember too that accessing ETFs can be pricey depending on the investment platform you use. You typically have to pay share dealing charges to trade, while traditional funds can be heavily discounted or free. This is particularly a problem if you are investing regularly rather than in a one-off lump sum.

Naked truth 2: Trackability

Accurately tracking an index or basket of assets is harder than it sounds. In fact, it can’t be done exactly because of the costs and administration involved. For example, indices don’t need to pay for share dealing, nor do they need to hold cash in case investors want their money in a hurry.

In addition, ETFs must obey regulations such as how much of the fund can be held in a single share, currently 10%. That would become a real headache if, say, GlaxoSmithKline invented a cure for the common cold and its share price inflated so much that the company represented 15% of the entire FTSE 100. The ETF simply wouldn’t be allowed to match such a large constituent. On the other end of the scale, some shares, typically smaller firms, may be illiquid and the ETF may not be able to buy or sell enough (or in time) to replicate what’s happening in the index.

To get around this, the ETF manager may use investments in other companies in the same sector to try to get a similar result. It goes without saying that some managers are better at this than others.

All of this is important because investors might miss out on the full return from the underlying assets if the fund doesn’t track them closely enough. You can work out which ETFs are top of the class by comparing the tracking error of each fund. This is normally displayed on the fund factsheet or KIID document as a percentage - the lower, the better, and preferably with a zero in front of the decimal point.

Naked truth 3: Liquidity

Contrary to expectation, many ETFs don’t actually own the assets they invest in. They tend to borrow them from entities such as pension funds or use derivatives. These financial instruments may not be easily tradable, or be subject to large swings in value, which could affect the fund’s liquidity, aka the ease of getting your cash back when you want it.

If there’s a run on the fund with lots of investors wanting to withdraw their money at the same time (hello COVID-19!), there could be a cashflow problem. And for less popular or more esoteric ETFs, which aren’t traded very regularly, a big seller can cause a similar scenario if there aren’t enough buyers to balance their exit.

Cashflow issues can manifest as a large gap between the share price of the ETF and the actual worth of the assets it holds, known as the net asset value or NAV. Selling when the share price is below NAV means you’ll get less for your shares than they are actually worth. Even the largest ETFs aren’t immune to this outcome. At one stage during the COVID-19 crisis, the share price of Vanguard’s $55 billion Total Bond Market ETF dropped 6.2% below the value of its assets (and it wasn’t the only one). For a fund supposed to be mirroring its chosen index, this wasn’t a good look.

Of course, in good times, the opposite can happen. If your ETF is suddenly hot property, buyers rush in, pushing the share price above the NAV. This is absolutely fabulous if you’re a seller but as a buyer you could overpay.

Naked truth 4: Ownership

Traditional funds, as opposed to many ETFs, own the assets they hold. In the case of shares, this gives them certain rights such as a seat at the annual general meeting where company policy is decided. Managers of traditional funds, especially if they are large shareholders, can and do pull companies up on behaviour they think is detrimental to shareholders’ interests or, sometimes, the wider community. If you’re interested in socially responsible investing, traditional funds may be a more influential route than ETFs.

Naked truth 5: Diversification

Diversification is one of the golden rules of investment and ETFs can slip up here. Some indices are skewed towards certain sectors – the S&P 500 is rammed with tech firms – and you may end up with more of your money concentrated in an area than you thought. You might also find a certain amount of overlap if you’re holding a selection of ETFs. American companies tend to make up a large percentage of global indices as well as US ones, for example.

Doubling down in areas isn’t always a bad strategy so long as you know you’ve done it (no unpleasant surprises) and the rest of your portfolio is properly diversified.

New wardrobe?

Far from being a fad, ETFs are now a significant sector in the investment world – and here to stay. Ease of use and a cheap price tag means they are a valuable tool for individual investors. But they may also have become a victim of their own success. There are about 7,000 ETFs now listed worldwide, according to Statista. A bewildering choice, no doubt, and that is in addition to the thousands of traditional funds out there. For the potential investor, looking beyond the marketing is essential. Comparing costs and tracking error is key to determining whether an ETF is a classic investment piece or a knock-off.

Date of publication: 8th September 2020

The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.

When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.

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