An index that allows cheaper way to invest in range of assets

First introduced in the US in 1993, there are now over 3,000 Exchange Traded Funds, known as ETFs. They are listed on over 40 stock exchanges worldwide and have attracted over US$900bn.

BlackRock, which owns the largest ETF provider, iShares, predicts the market will grow 30 per cent this year.

Purchasing an ETF is equivalent to buying an index in a share.

An ETF has one investment aim: to track the returns of a specific index.

Technically, they are a hybrid between open-ended funds (like unit trusts) and closed-ended (like investment trusts). They are open-ended in that the number of shares can expand or contract depending on saver demand.

They are closed-ended as ETFs are exchange listed and traded, meaning that they can be bought or sold at any time during the trading day just like a company share. Savers like ETFs for several reasons:

n where the whole constituents of an index are preferred to a selective fund with a manager who picks specific companies;

n where there is no actively managed fund available, such as Turkish equities or the spot price of gold;

n fast access instead of researching the best actively managed fund or stocks;

n to build a strategy with an ETF as the core with satellites formed by other ETFs or stocks or actively managed funds;

n low charges.

It is a myth to think that ETFs are only for the esoteric. ETFs are available for all major indices, such as the iShares FTSE 100 which follows the 100 largest companies by capitalisation quoted on the London Stock Exchange. An investment in this will incur an annual charge of only 0.4 per cent.

Most London-listed ETFs are exempt from stamp duty and eligible to be held in ISAs and self-invested personal pensions (SIPPs).

Low fees are one of the major attractions of an ETF. There are no initial charges (unlike a unit trust or OEIC where five per cent is not uncommon) and no exit fees.

The annual management charge is usually 0.2 to 0.75 per cent by comparison with one per cent annually for a tracker fund or 1.5 per cent for a managed fund.

To compare an ETF with any other investment product on charges, ask your adviser or provider for the total expense ratio (often referred to as the TER). An ETF has a very low TER, typically only 0.15 per cent compared with an average 1.6 per cent for an actively managed fund.

As an ETF is a share, there are also the costs of purchasing and selling.

As an example, stockbrokers Hargreaves Lansdown charge one per cent to buy and sell (minimum 10, maximum 50) and removes its 0.5 per cent annual fee if the ETF is held outside an ISA in their Vantage account.

There will be a tracking error which is the difference between an ETF's net asset value return and the underlying index return. Most ETFs will underperform an index by at least the cost of the fees charged by the provider.

Currently ten providers – notably ETF Securities, db x-trackers, iShares and Lyxor ETF – offer almost 600 ETFs on the London Stock Exchange. "Not all ETFs are the same as some use derivatives to either short or leverage the asset they are tracking," warns Tony Fisher of Ellis Bates, the Harrogate-based insurance brokers and financial advisers.

As losses using derivatives can be magnified, Mr Fisher advises against such ETFs except for professional investors. Instead opt for ETFs which seek to physically replicate the constituent parts of an index by purchasing in accordance with the market weightings and which are then held by a custodian.

Private client stockbrokers Killik say it is important to understand which index an ETF is following.

They give the example of a price index or a total return index (which takes account of income) and whether it is marked weighted, equally weighted or weighted in a different manner, whether it is a capped index (meaning the weighting of some of the index constituents is capped), whether it is a spot price index or a futures one (such as usually used for commodity ETFs).

Stocktrade, part of stockbrokers Brewin Dolphin, charge 0.5 per cent (minimum 15) for execution-only ETF deals. Among the most popular – all priced in US dollars – are:

n iShares MSCI AC Far East excluding Japan (tracks Asia but omits India and Japan);

n iShares FTSE/Xinhua China 25 (which tracks the 25 largest Hong Kong listed stocks);

n iShares S&P India Nifty 50 Index Fund (covering the top 50 Indian stocks).

The first two are London listed and the last quoted on the New York exchange.

There are many variations. For instance, if seeking income, consider IAPD-iShares DJ Asia/Pacific Select Div 30, which tracks the 30 highest dividend-paying stocks from developed countries in Asia and the Pacific.

An ETF can also provide access to a more exotic market, such as Vietnam, whose shares are far cheaper than either China or India. In this connection, consider db x-trackers FTSE Vietnam Index ETF.

Most fund managers ignore soft commodities like coffee and corn and yet such staples are in global demand and so arguably should form part of a balanced portfolio. Again, the specific entry to such markets is via an ETF.

If you wish to invest in gold, a gold ETF will not carry the high charges of holding gold bullion. If the combined subjects of real estate and the Far East appeal, look at the iShares Asia Property Yield fund.

There are risks with ETFs. Never invest in one which is not clear or where the underlying investments are not revealed, such as an index of hedge funds.

Watch exchange rates as many ETFs are denominated in euros or US dollars. Watch trading charges as brokers' fees can quickly erode profits if you are dealing frequently which may make a conventional tracker better value.

Ask if any derivatives are involved. Whilst their use can reduce the tracking error, it introduces another risk and so ask what third party collateral is to be used.

'Exposure to broad equity markets'

Nick Crellin, 43, commutes between his family home in York and London where he is a partner at stockbrokers Killik & Co.

He said: "I view equity exchange traded funds (ETFs) as a means of getting quick low-cost exposure to broad equity markets and the ability to focus on sectors such as agriculture or other asset classes such as precious metals."

Nick holds ETFs in iShares Brazil, which tracks the country's leading shares. "It has the wealth potential of an emerging market," he said.

He also holds Powershares Global Agriculture ETF.

Nick, who is married to Michelle and has three children, warned that not all ETFs are equal: "Some allow investors to 'short' an index which means making money in falling markets. They need to be fully understood by investors."

n Killik is an advisory stockbroker and charges 1.65 per cent commission up to 25,000 and annually 25 for an account and 19 for custody. Tel: 020 7337 0520.