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Investing in funds: What is an ETF and how should I use one?

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Exchange traded funds (ETFs) have become a popular way to access the stock market. They are run by global investing giants such as Vanguard or BlackRock and offer cheap, easy access to a diversified portfolio of shares. But how should investors approach them?

 

First of all, what exactly is an Exchange Traded Fund?

ETFs are bought and sold like normal shares but are actually a form of fund (a mixed collection of shares and other assets).

They are a ‘passive’ option. Instead of having a human fund manager who picks the investments, passive funds simply track the performance of a stock market index, such as the FTSE 100 or S&P 500.

ETFs have become super-popular because they’re cheap and pretty easy to understand.

 

How much does an ETF cost?

To give you an idea of cost, the iShares Core FTSE 100 Ucits ETF – they also come with catchy titles – has an ongoing charge of around 0.07%. That compares to somewhere between 0.65% and 0.75% for a normal ‘active’ investment fund.

You might not think that matters very much, but £10,000 invested for 20 years at 5% growth gives you £27,126. If that growth rate drops to 4.25%, to take into account the higher charges, your overall pot is just £23,361.

 

What can I invest in with an ETF?

In terms of the type of ETFs available, you name it, they track it. FTSE 100, FTSE 250, FTSE All Share, FTSE Small Cap; international indices such as the S&P 500, Eurostoxx 50 or MSCI Emerging Markets.

And not just shares. You can also track commodities, such as gold or oil. And it is possible to track fixed income (bond) indices, plus property or infrastructure.

Then you have a smorgasbord of options within each category – ETFs that take into account ethical considerations or environmental criteria, for example, or ETFs that focus on dividend-paying companies, or high growth companies. The choice is yours.

 

The most effective ways to use an ETF

ETFs for beginners

ETFs are useful as an entry-level investment. They offer cheap, easy, diversified access to markets. If you’re really not sure what you want, or don’t want the palaver of picking a fund manager, this is a quick and easy way to get invested. Granted, you could make more money with an active manager, but you could also make far less, so ETFs are a happy middle ground.

 

ETFs for more seasoned investors

For more seasoned investors, there are broader uses for ETFs. The first is to take short-term exposure to markets. David Coombs, head of multi-asset investment at Rathbones, explains how his team uses them:

“ETFs help us manage risk. We would use them when we get significant inflows into our funds and we need to get money to work quickly. We would take market exposure through ETFs.”

In other words, if you don’t want to take the risk of being out of the market (either because you believe it will go higher, or you don’t want to miss out on dividends), ETFs are a good holding position until you decide the best long-term home for your money.

 

Equally, says Coombs, ETFs are useful for short-term geographic or sector trades. If you really believe that the Indian market is in for a short-term bounce, ETFs are an easy way to take that position. You can also take positions in certain sector ETFs. This can help you manage different market conditions - you may want a utilities ETF when times look tough or a technology ETF when you want all-out growth.

 

Exposure to commodities is the other major reason to use ETFs. Coombs says:

“We use passives for gold and other commodities. These are the only times when we use ETFs for long-term investment.”

In general, ETFs are a good way to take exposure to gold, which can be a useful asset to hold during times of deflation. Equally, oil ETFs can give proxy exposure to the rise and fall of the global economy.

 

Fixed income ETFs draw mixed views. Coombs doesn’t use them at all, pointing out that they will often have highest exposure to the most indebted companies and corporates. In general, ETFs don’t work as well for smaller or illiquid markets, such as emerging markets, property and corporate bonds, so may not be the best choice for investors who want exposure to those areas.

 

Who should I buy an Exchange Traded Fund from?

In general, you’re better off with the big names - Vanguard, iShares, Fidelity or HSBC - which tend to be cheaper and widely available.

To compare customer ratings and expert views of investment providers like these, check out our independent Best Buys tables.

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