ETF's - Exchange Traded Funds - Are They Right For You?

What is an ETF?:- An ETF is similar to a mutual fund in as much as it represents an investment in a collection of stocks, bonds, commodities etc, but with one significant difference - it can be traded on the stock exchange. 

To illustrate this difference more clearly, it helps to understand what happens when you buy units in a mutual fund. The price of these is based on the net asset value of the fund, which is calculated once a day. No matter what time of day you buy, you're getting a fixed price for that day. ETF's also have a daily net asset value, but the shares can differ in price throughout the day, which provides an opportunity to buy and sell at a profit. If the shares are trading below net asset value they are said to be at a discount, and if they're above NAV, they're trading at a premium.

Most ETF's are index trackers - they hold securities that mirror those that make up the index itself, the objective being to replicate the performance of that index. The advantage of this from a trading perspective is that it gives the trader an opportunity to benefit from intraday index moves by buying or selling ETF shares accordingly. Or he/she can take a longer term position if that's the preferred strategy.

ETF's have been around in America since 1993, with the introduction of the SPDR (Spider), which tracks the S&P 500 index. Since then the number of ETF's in the U.S. has grown to over 1500. ETF's came to Europe in 1999.

Types of ETF's: - the most popular ETFs are those that track indexes, like the SPDR mentioned above. In the UK they include the iShares plc FTSE 250 and the FTSE 100 UCITS. There are also Bond ETF's, which are seen as attractive investments in times of recession when the stock market is not so popular, and commodity ETF's, which hold investments in precious metals like gold, silver, and palladium. Agricultural and energy ETF's also fall into this category. Finally there are currency ETF's, which track the performance of all major currencies and some of the minor ones too.

Cost advantages: - Most ETF's are passively managed, which means the manager simply tries to replicate the relevant index by investing in a representative sample of the assets that make up that index. The passive manager is not trying to outperform the market, but is just attempting to replicate the performance of the index. A lot of this is done using computer modelling. This needs less hands on management, which results in lower fees. Active management on the other hand, which some ETF's are subject to, is an attempt to outperform the market. In this respect there is a similarity with mutual funds, and the charges are subsequently higher for ETF's managed this way. If you're contemplating an ETF investment, find out which style of management is in operation.

Generally however, ETF's have cheaper charges, averaging less than 1%, whereas mutual funds can range from 1% to 3%. Over time this becomes a significant difference.

In terms of taxation, the UK investor needs to be aware of the taxation status of any gains accrued from ETF investment. If the tax status is either 'reporting' or 'distributor' you'll pay capital gains tax. Otherwise it will be income tax, which can be much higher. Also bear in mind that any dividends received are seen by HMRC as income, and are treated as such. And remember that if your ETF was issued in another country you may be subject to the tax laws applicable there.

ETF's vs Mutual funds: - Some of the differences between these two have already been mentioned above, so the question here is, which one is right for you?

It depends on what kind of investor you are. If you like to be active in the market the ETF's offer you the opportunity to trade all day every day. You can go long or short as you wish. Management costs are usually lower, though if you trade a lot you need to take into account the costs of buying and selling.

If on the other hand you're more passive then mutual funds might be the better option. You buy at that day's price and hopefully watch your units increase in value, a process assisted by the ostensibly superior expertise of the fund manager. You might pay a bit more for the privilege of course.

In performance terms ETF's and mutual funds seem to be close. In researching the year to date returns for the top performing funds I can find figures for both mutuals and ETF's ranging from 16% to 100% for ETF's, and from 14% through 1,290% for mutuals! Would seem to give the lie to the often quoted opinion that professional fund managers tend to underperform. I would only add the also often quoted caveat that past performance is no guarantee of future performance either....

The ETF market has come a long way since its inception in the U.S. in 1993. There are ETF's to track just about every index around. With China and other emerging markets making their mark on the world economy, we are seeing ETF's coming through that are targeting this sector. At the moment, with the Chinese economy in a slower growth period, the year to date returns don't look impressive. But if you are a prospective investor in ETF's this could be an interesting and potentially profitable way to go longer term. The same principle applies to Brazil, Russia and India, the so called BRICs countries.

To conclude: - ETF's offer similar attributes to mutual funds, but give the more active investor the option to trade shares, with lower management fees and easy liquidity. You are free to hold onto your ETF shares long term if that is your preference, and it would seem that if you do you'll make returns comparable to mutual fund returns, without the higher charges. So in a sense it's the best of both worlds.