Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) are comprised of a range of open-ended investments which are listed on a stock exchange and are traded and settled like shares. They are a form of passive investment which are designed to replicate the performance of an index, market sector, currency or commodity.

Important Information and Risk Warning

ETFs are generally low cost investments which allow you to track the performance of an index or commodity.  These are usually classed as 'Physically Backed' or 'Synthetic'. 

As the name suggests, 'Physically Backed' means that the fund buys the assets that make up the tracked index.  This can take the form of a full replication where the fund, for example, would buy all the constituents of the FTSE 100 on a FTSE 100 tracker.

An alternative approach would be optimisation where the fund would invest in a representative sample, for example a FTSE All Share tracker. Synthetic ETFs are not backed by physical assets and are instead constructed using financial derivative transactions. There are therefore some important differences between ETFs and other equities which all potential investors will need to consider before buying. These are summarised below:

Counterparty Risk

Synthetic ETFs derive their returns by entering into derivative transactions such as swap agreements or futures contracts with counterparties rather than by purchasing the relevant assets themselves.

If the counterparty (typically an investment bank) to the ETF were to fail, the ETF may lose a part or all of the funds they had invested. Such losses would then be shared directly with any holders of the ETF.

An example of counterparty risk includes those commodity ETFs which were suspended for a time in 2008, when the American insurer AIG failed.

We would strongly recommend that you read the relevant ETF prospectus to understand whether the fund is backed by physical assets or is otherwise underwritten by financial derivatives.

Stock Lending

Another form of counterparty risk exists even with physically backed ETFs. This occurs when an ETF provider chooses to generate additional revenue by lending the assets they hold to third parties, such as an investment bank. If that third party were to fail and the exchange traded investment is unable to recover its holdings, investors would suffer a loss.

Tracking Error

Tracking error is where there is a difference between the performance of the ETF and the performance of the index or commodity it is designed to track.
There are a number of different reasons that this may occur, with the main ones including:

• Transaction and management costs

Annual charges made on the ETF by the provider for managing the ETF will lead to the ETF underperforming its benchmark.

Also, each time the fund has to restructure or rebalance the portfolio, for example when companies move into and out of the FTSE 100, transaction costs will be incurred. Both of these factors can lead to a difference in the performance of the ETF when compared to the asset it is tracking.

• Liquidity

ETFs which are designed to track unusual or exotic asset classes may find it difficult to trade in specific investments. For example, an ETF tracking an asset class in an emerging market. In such circumstances the ETF provider may choose to invest in a different company whose shares are readily tradable and whose performance is expected to move in line with the first. However, as the shares of different companies will not perform in the same way, this type of replication strategy might lead to tracking error.

• Costs of maintaining derivative positions

ETFs that use the futures market and derivatives to track, short or leverage an index, commodity or currency will need to rebalance the underlying holdings on a daily basis to reflect price movements and the new weightings of the index. Every time a fund is rebalanced a tracking error occurs, which over time can have a material effect on the performance of the fund.

Currency

Where an ETF is priced in a currency which is different to that in which the assets are priced, investors will face currency risk. An example of this would be an ETF priced in sterling which was invested in and tracking the Dow Jones Industrial Average. 

Leveraged and Short ETFs

Leveraged ETFs are complex instruments which use futures and or derivatives to achieve returns which exaggerate the movement of the underlying asset. For example, rising (or falling) by 2% for every 1% rise (or fall) in the underlying asset.

Short funds employ similar strategies, but will deliver a mirror opposite performance. For example, for every 1% fall in an asset, a leveraged short fund would hope to deliver a 2% increase.

With both types of fund losses can be sustained much more quickly than with a more traditional approach to investment. However, such losses would be limited to the amount invested.

Taxation

The majority of ETFs are based offshore and their particular status will dictate how your gains (or losses) will be treated for tax purposes. A gain made when selling certain funds will, for example, be charged to income tax within the UK.  Please familiarise yourself with the particular tax treatment of any ETF you are considering investing in and consider then in the context of your own individual circumstances.