The development of exchange-traded funds, or ETFs for short, has had a big impact on ordinary UK investors providing the likes of you or I with the means to gain low-cost access to a variety of different markets and asset classes.
From just one product tracking the FTSE 100 back in 2000 there are now around 1,500 exchange-traded funds on the London Stock Exchange. Their names can often be longwinded and confusing and it can be difficult to choose the right product for you.
Getting the right ETF is important. There has been considerable innovation in the ETF market and there are now products based on complex underlying assets which offer both short and leveraged exposure and ETFs which track a selection of stocks based on criteria such as volatility or dividend yield.
Most ETFs are so-called ‘passive’ products which simply seek to track the performance of an underlying index. This could be, for example, the FTSE 100 or its US counterpart the S&P 500.
WHY AN ETF IS OFTEN A CHEAPER OPTION
Typically exchange-traded funds are cheaper than actively managed funds. In some cases you can pay as little as 0.06% a year while a lot of funds charge upwards of 1%. The disparity reflects the expense of paying a fund manager to make investment decisions.
Because they trade on the stock market ETFs allow you to rapidly express a view on an industry, economy or asset class.
Unlike many mutual funds, there is no minimum investment and you immediately know at what price you are investing. A traditional fund is priced daily at a level which you only learn after confirmation of your trade has come through.
Tracking error is something you need to be aware of when choosing ETFs, especially index-based ones.
In a nutshell, tracking error reflects how closely an ETF tracks its benchmark on a day-to-day basis. So, a low tracking error indicates the fund has consistently tracked its benchmark.
As a rule of thumb – and assuming otherwise perfect tracking – an ETF should underperform its benchmark by an amount equal to annual charge.
This is the latest in a series of guides on the basics of the financial markets to appear on our website in the coming weeks.