An exchange-traded fund or ETF is a pooled investment vehicle. Like a mutual fund, an ETF offers investors a proportionate share in a pool of stocks, bonds, and other assets.
Unlike a mutual fund whose shares are priced daily based on the value of its assets, an ETF can be bought or sold throughout the day on a stock exchange at a market-determined price.
They can be used to track individual stocks and shares, indicies such as the FTSE 100, commodities and bonds - and typically come with low charges.
Although historically a passive instrument, which merely aimed to replicate the performance of the relevant underlying market, there are an increasing number of smart beta and active ETFs which either apply some kind of filter to the market or even have stocks selected by a fund manager.
A WORLDWIDE PHENOMENON
ETFs are not just a UK phenomenon but are available worldwide. In fact they are most popular in the US, where nearly half of the ETF market is accounted for by retail investors compared with a much smaller proportion in Europe. The remainder is made up of institutional investors - investment banks, fund managers etc...
Several factors account for this disparity. The regulatory set up in the UK was historically biased against products - such as ETFs - which did not pay commission to IFAs (Independent Financial Advisers) who therefore had very little incentive to recommend ETFs to their clients. That changed with the introduction of the Retail Distribution Review in 2012 which banned the payment of commission to IFAs.
Another issue has been the debate around the way ETFs replicate or track their underlying index. Physical, or cash-based, ETFs are those whose providers actually purchase and hold the assets or securities of the index they track. Should the provider go out of business, the investor has direct recourse to a ring-fenced pool of assets.
Synthetic, or swap-based, ETFs hold no underlying assets, but are financed by a counterparty, usually an investment bank, and vary in price more precisely equivalent to the return on their respective index, including capital gains and dividends. While a synthetic ETF can be much more accurate than the physical ETF in tracking, you are exposed to the risk of the counterparty hitting financial difficulty. The US has largely been spared this discussion as the vast majority of products in this market are physically replicated.
GOOD NEWS FOR INVESTORS
It is important that investors understand exactly what they are investing in but comparisons with derivative instruments such as Collateralised Debt Obligations (CDOs) are probably unfair. Even when an ETF uses synthetic replication it holds collateral to mitigate counterparty risk. Although the good news for investors who feel more comfortable with a physical product is that the majority of providers now offer physical ETFs on mainstream markets.
