What are Exchange Traded Funds?
Exchange Traded Funds are pooled funds that track a particular investment index in the same way that an index-tracking unit trust or OEIC does. Bought and sold in exactly the same way as any other share, they vary from relatively low risk corporate bond and property funds to high risk funds for a single emerging market. They are suitable for investors who want a diversified portfolio but do not have the skills or the size of funds needed to invest directly in shares or bonds.
They offer an easy, inexpensive way for investors to build a global portfolio including the three main asset classes of shares, bonds and property. Simply buying one share in each ETF will give investors exposure to every developed stock market, many of the fastest-growing emerging markets as well as to bonds and property, which are a key part of a diversified portfolio. Few people will want to have every fund in the range but they can be used to build a portfolio to take account of the growth, income and risk requirements of any investor.
ETFs pay dividends in the same way as any other share although the yield and distribution dates vary from fund to fund. Unlike index tracking investment and unit trusts, the price of ETFs is updated throughout the day so their value can be constantly monitored. More adventurous investors can use ETFs for a variety of trading and risk-management techniques, such as shorting and hedging risk.
Disadvantages
While ETFs are less risky than buying individual shares, their prices can still be very volatile, rising and falling depending on sentiment towards shares in general and their markets in particular. The individual country and emerging market funds, in particular, are high risk and can be very volatile. Emerging markets are more volatile than more developed UK and US markets. The fewer the stocks in the index, the bigger the risk: the China ETF includes just 25 stocks which means it is vulnerable to a poor performance from any one of these companies while the S&P 500 will not be dramatically affected by the results of one of its components. Although ETFs are priced in sterling, the underlying indices are in local currency so you may be exposed to the risk of exchange rate fluctuations.
How to Buy Them
ETFs are bought and sold through stockbrokers in the same way as ordinary shares, except they do not carry stamp duty. Many of the online and telephone broking firms will be able to buy and sell ETFs. A stockbroker or financial adviser will be able to advise on which funds are most suitable for individual risk profiles.
Tax Treatment
Dividends on ETFs are paid after deduction of basic rate tax; higher rate taxpayers have to pay an additional charge. Capital gains on profits made on the shares are subject to capital gains tax. There is currently no stamp duty on purchases.