WHAT IS AN ETF AND HOW DOES IT WORK?
Exchange Traded Funds (ETFs) are index-tracking funds, listed and traded on a stock exchange. When buying a share in an ETF you are effectively buying a portion of the assets of a fund. These underlying assets are usually shares in the constituents which make up the index or sector. By using ETFs, they can allow you to gain exposure to both domestic and overseas indices such as the FTSE 100 and S&P 500 in one simple transaction. Their aim is to track an index by holding the underlying shares or a derivative equivalent, allowing you to diversify a portfolio to reduce risk.
HOW CAN I TRADE IN ETFs?
Under the current regulations and the rules of the Financial Conduct Authority (FCA), we are required to satisfy ourselves that you have the experience and knowledge to enable you to understand the risk involved when dealing in ‘complex instruments’ such as some ETFs. Therefore, before you can trade in ETFs you must undertake an assessment to demonstrate your knowledge and understanding of complex instruments, and this will involve completing our Complex Instruments: Appropriateness Assessment Form.
THE BENEFITS OF ETFs
The annual management charges on ETFs are usually quite low, ranging from 0.07% to 0.55% which makes them look very attractive when compared to those of Unit Trusts which can be wide ranging. In addition, ETFs do not have any hidden charges such as initial or exit fees, they only have an annual management charge, which will be reflected in the share price - you only pay the standard commission that your stockbroker charges to buy and sell. Furthermore, there is no Stamp Duty to pay on shares purchased within many ETFs.
Some ETFs actually hold the underlying shares, and so collect the dividends paid by the companies and distribute them to the holders of the ETF shares, thus providing you with an income stream.
THE RISKS OF ETFs
Providers have begun to use different methods to gain exposure to the underlying investments, for instance ‘swap-based’ ETFs replicate the performance of an index through using index swap agreements. The complex nature of these agreements, involving ‘swapping’ assets between two or three different parties in order to generate a return equivalent to that of the index being tracked, means that there are additional risks involved that may not be apparent initially. In particular, although the return should still match the index in strong market conditions, the basket of assets may not replicate it and may potentially hold illiquid assets instead. Therefore, if market conditions worsen sharply, the provider may be forced to sell illiquid assets at a significant discount, which in turn will affect the price of the ETF and, in the worst case, may delay payment. Secondly, by introducing additional counterparties into the equation, the risk is heightened because the investment is only as safe as those parties the ETF provider is trading with. If they fail to honour the swap agreement or get into financial difficulties themselves, then the investment will also be impacted and might fail altogether.
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