What is an exchange traded fund?

Exchange traded funds (ETFs) are tracker funds which aim to replicate the performance of a given market index – the FTSE 100 for example. They are listed on a stock exchange and can be bought and sold like shares.

Why invest in an ETF?

ETFs are generally a low cost way to invest because there is no stock selection by an active fund manager.

They are transparent and often offer exposure to more exotic asset classes that have traditionally been difficult for retail investors to access.

How do ETFs work?

ETFs work either by physically buying a basket of investments in the index they are tracking or by using more complicated investments to mimic the movement in the index.

Investment decisions are made automatically according to the fund’s rules.

The difference between an ETF and an index tracker fund is that an ETF is a fund which can be traded at any time of the trading day; whereas an index tracker fund is a mutual fund, which can only be traded at one or two points in the trading day.

With an index tracker fund, you pay both initial and annual management charges, as well as the stamp duty charged on trades made within the fund itself.

Some ETFs aim to replicate the performance of indices by using derivatives (for example swaps) rather than shares. A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time.

These funds are known as ‘synthetic ETFs’ (in contrast to the ‘physical’ replication where a fund buys the underlying asset).

Synthetic ETFs expose investors to the risk of losing money in the event that the party supplying the derivative becomes insolvent.

Investors should ask before they purchase an ETF whether it invests in shares or is based on derivatives, as it is often not immediately obvious.

What are the risks?

• The tracked index can go down as well as up and you may get back less than you invested like any other investment.

• ETFs still incur charges, therefore will always underperform the index by a percentage as the charge will eat into your investment pot. This is more noticeable over a longer period of investment.

• Synthetic ETFs rely on a counterparty underwriting the risk, and so carry the risk of counterparty failure (for example, Lehman Brothers in 2008).

• Assessing the risks in synthetic ETFs can be difficult.

• Many ETFs are not based in the UK and if so are not covered by the Financial Services Compensation Scheme. Under the FSCS rules, investments up to £50,000 are protected.

• You can sell at any time but the price you will get will depend on market conditions on the day.

• ETFs offer minute-to-minute pricing because they trade like a share; so may be more appropriate than tracker funds for investors who trade more frequently.

What about tax?

Dividends from ETFs are subject to income tax. The income tax rate depends on an individual’s income, but the rate can range from 20% to 50%. Normal capital gains tax applies on gains above £10,680 per year.

Where can I buy ETFs?

You can buy ETFs like you would normal stocks – through a broker for a fee. many online and discount brokers offer ETFs.