ETFs: a cost-efficient way to access markets?

Written by: Tom Bartolacci
Exchange-traded funds (ETFs) have been around for years, but they haven’t yet achieved mainstream appeal in the UK. Given their simplicity, we believe it’s only a matter of time before self-directed investors embrace ETFs as a core investing solution.

More similar than different

So, what are ETFs and how are they different from “traditional” funds such as unit trusts and OEICs? The first thing to say is that there are more similarities with traditional funds than differences. For example, ETFs pool the money from many like-minded investors and give that money to a professional manager to invest it in markets, using scale to achieve cost-efficiency.

The majority of ETFs available in the UK are UCITS products, which means they are governed by the same regulations and have similar investor protection frameworks to unit trusts and OEICs. Like traditional funds, your ETF investments are ring-fenced from the balance sheet of the fund company, so it’s safeguarded in the event of the fund manager becoming insolvent.

Most ETFs are passive

You can invest in equities, bonds or a variety of other asset classes through an ETF. There are ETFs that invest actively (that is, they try to outperform a given market or benchmark), but the majority of ETFs are index or passive products, designed to track the performance of an index rather than trying to beat it. That’s a subtle difference compared to traditional funds, where both approaches are available but the majority of funds are actively managed.

Passive investing brings lower charges, because of the lower research costs involved in tracking an index. As a result, ETFs tend to have lower ongoing charges than traditional funds. Passive products also typically have a narrower dispersion of returns around the index than active funds, which is helpful from a risk-control perspective.

Trading places

The biggest difference between ETFs and traditional funds is how they trade. Unlike traditional funds, ETFs are listed on a stock exchange and they are priced throughout the day. This means that you can buy and sell during the trading day in real time rather than having to wait for the next valuation point, as you do with a unit trust or OEIC.

It also means you’ll need a stock broker to access ETFs, and this difference is probably the main reason why ETFs are yet to achieve mainstream appeal. The larger fund platforms are now offering brokerage services, which should broaden ETF access for retail investors. It’s wise to check the cost of dealing, because if brokerage fees are high, that could outweigh the cost advantage from ETFs’ lower ongoing charges.

What to look out for

There are a lot of ETFs out there. Every day, more and more ETFs are being launched that offer access to niche areas of a market or asset classes, like Asian real estate or gold mining companies. With all the choice on offer, it may be tempting to chase the newest “hot” product or investment trend. These may even have a place in some portfolios. However, most investors are best served by low-cost, broad-based, and well-diversified investments, like stocks and bonds.

Also, just because you can trade easily with ETFs, doesn’t mean you should. We believe most investors should not use ETFs to speculate, or trade frequently. Indeed, our research with actual shareholder transaction data shows most people use ETFs in a prudent, buy-and-hold manner.

A useful tool

ETFs are more established in the US than they are in the UK, and the pattern of adoption there gives us some clues about how the market might develop here. In the US, institutional investors were the early adopters because they recognised that ETFs were a great way of achieving easy, low-cost access to markets. Wealth managers and financial advisers came next, followed by the retail investor as market access improved and investors became more comfortable with their structure.

We expect the UK market to follow a similar trend. Institutions and wealth managers are already significant buyers of ETFs; we are seeing increasing adoption by financial advisers; and forward-thinking self-directed investors are buying in growing volume. As access to ETFs continues to grow, we expect them to become well-established as a core portfolio building tool.

Tom Bartolacci is head of capital markets at Vanguard Asset Management

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