What are the pluses and minuses of ETFs?

by , 22nd April 2018

Here’s a look at the pluses and minuses of ETFs.

The pluses

Cheap

The biggest plus point for ETFs is that they tend to be cheap. One of the cheapest in Europe is the Lyxor Core Morningstar UK UCITS ETF (LCUK) which charges a fee of just 0.04% a year. So if your investment is worth £1000, you’ll pay an annual charge of just £4. (There are a few ETFs in the US that are even cheaper, charging just 0.03% a year.)

Simple

Simplicity is another attraction. You can trade ETFs on the stock market which means you can buy and sell them at any point during the trading day. Although they work very well for long-term investors, mainly thanks to their cheapness, ETFs are also useful tools for short-term traders. That’s because they can give you quick exposure to a huge range of markets you might want to trade.

Wide range

Indeed, the wide range of available ETFs is another attraction. Yes, you can use ETFs to invest in well-known markets such as the FTSE 100 or the S&P 500, but there also ETFs that track much more obscure markets. There are single country ETFs: for example, Peru. There are single commodity ETFs – such as gold or silver – as well as ETFs that track a basket of commodities.  And there are bond ETFs, currency ETFs and more.

Previously, private investors would have struggled to invest in some of these assets, so ETFs have opened up the world for private investors.

Transparent

ETFs are also very transparent. Most provide daily portfolio updates so investors can see exactly where their money has gone. The most transparent ETFs are ‘physical’ ones where the ETF invests directly in the assets they follow. So a physical FTSE 100 ETF buys shares in all the companies in the Footsie. The alternative is synthetic ETFs which track the movements of a particular index by using derivatives such as options. (Some ETF use a mix of the two.)

Reliable

What’s more, ETFs are reliable. If you invest in an S&P 500 ETF, you only need worry about the performance of the US market. But if you go for an active US fund, you may end up worrying about both the performance of the overall market and also the performance of the active manager. In other words, with an active fund, the value of your investment might fall even if the S&P as a whole goes up. That shouldn’t happen with a passive ETF, and the vast majority of ETFs are passive.

Smart beta

The rise of smart beta ETFs is also good news for investors. They follow particular investment strategies such as ‘value’ or ‘momentum’ and they do so by implementing a clear, rules-based strategy. This makes it easier for investors to pursue a particular strategy.

Before the arrival of smart beta ETFs, you would have to put your money into an active ‘value’ fund if you wanted to follow a value strategy. An active value fund is almost certainly more expensive than a smart beta value fund, and you’re also replying on the manager of the fund sticking with a value strategy. With active funds, you often see a phenomenon known as ‘style drift.’ This is where an ostensible value fund, perhaps with the word ‘value’ in its title, departs from the strategy and invests in very expensive shares.

The minuses

Trading fees

Because ETFs are traded on stock markets, you will have to pay a fee to your broker or trading platform when you buy and sell ETF shares. Often these fees are very low, but they still represent a cost. Trading fees are one reason why it’s not a good idea to overtrade ETFs. That applies to ordinary shares too.

Not all diverse

Many ETFs give you wide exposure to a large number of companies or assets. But some of the esoteric ETFs are not anything like as diverse. We mentioned earlier that you can invest in Peru ETFs – you’d be taking a big risk if you put a sizeable proportion of your total wealth in that kind of single country ETF.

Liquidity

Some of the smaller, more niche ETFs may not be that liquid. This may be an issue if you want to sell a large number of shares. If you’re investing sizeable sums, you may want to look at the bid/offer spread for the ETF. The larger the spread, the more illiquid the ETF.

The liquidity of an ETF is also affected by the liquidity of the underlying assets held by the ETF. FTSE 100 shares are all sizeable companies that are frequently traded. So they’re liquid assets and that liquidity means that a FTSE 100 ETF is very likely to be very liquid. (Some FTSE 100 ETFs may be more frequent than others – it depends on how big they are and how frequently the ETF shares are traded.)

But if an ETF invests in illiquid assets like commercial property, then that ETF won’t be as liquid as a FTSE 100 one.

Verdict

So ETFs have some definite pluses and minuses. But you won’t be surprised to learn that we think the pluses outweigh the minuses. We probably wouldn’t go to all the effort of launching a website focused on ETFs if we thought they were a rubbish investment vehicle!