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Understanding ETFs trading

November 2017


Tags: Investing Strategies

Exchange traded funds (ETFs) can be a low-cost way for investors to gain diversified exposure to financial markets.

The cost of an ETF is an important factor and a few percentage points difference in the charges for an investment can make a big difference to long-term returns.

However, pricing on the majority of mainstream ETFs is increasingly competitive and there are other things you need to think about when selecting the right ETF for you.

Unsure what an ETF is?

We’ve got you covered our short video explains what is an ETF.

ETFs: an introduction

Originally created as tools for institutional investors, ETFs have proven to be increasingly popular with individual investors. In the first seven months of 2017 a record level of $391.3 billion was invested in exchange traded funds globally.

The low cost of ETFs is appealing for investors and the added attraction for many is that they offer a unique combination of features associated with both funds and individual shares.

Like a fund, they diversify an investor’s money across a range of underlying holdings thus spreading the risk. But in addition they are traded on the stock market, meaning they can be dealt online at a live market price throughout the day, just like regular shares.

The ease with which they can be bought and sold, their tax efficiency and their relative low costs have seen ETF markets grow exponentially, as private investors have added them to their portfolios.

The sheer breadth of options available can be bewildering and some of the key points of comparison that investors typically use, such as index composition, fees, replication method and whether the fund is accumulating or distributing, can be equally perplexing.

 

Range of choice

Some ETFs track an index which is based on a certain criteria such as income from dividends, however, the majority are still passive products which simply seek to track the performance of a more traditional index such as the FTSE 100.

You might have heard of tracking error and this is something else that you need to be aware of when choosing ETFs, especially index-based ones.

In a nutshell, tracking error is the volatility (as measured by the standard deviation) of a fund’s return difference versus its benchmark. So a low tracking error indicates the fund has consistently tracked its benchmark.

You might also hear people refer to tracking difference, this is a separate issue. And it’s usually negative, meaning that the ETF underperforms its benchmark.

As a rule of thumb – and assuming otherwise perfect tracking – an ETF should underperform its benchmark by an amount equal to its total expense ratio on an annual basis.

See our ETF Select 100    Discover more about ETFs

 

Emerging trends

One trend that is likely to be more evident in the UK is something that is big in the US at the moment. And that is smart beta, also known as strategic beta.

Smart beta ETFs are something of a hybrid – using aspects of both active and index investing. These funds focus on incorporating stocks and bonds that have certain characteristics attractive to investors, such as low volatility, good dividend yield or strong company performance.

By using a mix of strategies the aim is that they will enable investors to achieve better returns by riding out volatile markets and achieving a higher income.

With smart beta strategies, investment exposure to specific elements of return (quality, value, momentum, size) is transparent to investors. Smart beta ETFs have an added element of transparency in that holdings are disclosed daily, unlike active mutual funds that typically display holdings on a quarterly basis.

Smart beta ETFs tend to be more expensive, but the argument is that the additional cost is more than made up for by the superior performance. Because these products are relatively new, it remains to be seen if this is actually the case.

 

Tools to help

Financial information providers Morningstar and Trustnet both provide rating services for ETFs. For the Trustnet service, passive funds will be awarded between one and five ‘Passive Crowns’, based on their ability to track their index over a three-year period. The Morningstar rating offers a measure of a fund's performance versus its peer group and is based on a 1 to 5-star rating.

The table below shows the sterling denominated ETFs which achieve the performance of their benchmark through physical replication (see Jargon Buster) and have a rating of five ‘Passive Crowns’ from Trustnet.

Source: Trustnet

See our ETF Select 100    Discover more about ETFs

 

ETFs and dividends

Though exchange traded funds (ETFs) – also known as exchange traded products (ETPs) – are often seen purely as a low-cost way of achieving the performance of an underlying market, many also offer income and in some cases the returns can be generous.

In the same way as mutual funds, there will typically be accumulating and distributing versions of the same ETF. The former will reinvest dividends (or coupons in the case of bonds) back into the fund while the latter distributes income to holders. ETFs track the performance of a basket of stocks (or in some cases other assets such as bonds). They can be based on a mainstream index like the UK’s FTSE 100 or the S&P 500 in the US, but may also track an index focused on a specific sector or even an investment style (also known as ‘smart beta’).

If they invest directly to replicate the performance of these indices then they receive the dividends associated with these holdings. If the ETF distributes income these are collated in a cash account and usually paid out on a quarterly, semi-annual or annual basis.

The situation is a little more complex for synthetic or swap-based ETFs. As a quick reminder these products achieve the performance of their benchmark through derivatives contracts or swaps provided by brokers and investment banks. (In theory this means investors are exposed to counterparty risks associated with these swap providers – though there are safeguards in place.) Synthetic ETFs receive the performance of the total return index from their swap provider and this includes dividend payments as well as any price changes in the underlying companies.

The dividend portion is then separated out and delivered to investors. In the same way as an individual share, an ETF will also trade ex-dividend – with the instrument dropping in price in proportion to the expected level of payout. There are specialist ETFs which cater to an income-based investment strategy.

iShares UK Dividend (IUKD) and db X-trackers Euro Stoxx Select Dividend 30 (XD3E) track the 30 highest yielding eurozone stocks, while SPDR S&P UK Dividend Aristocrat (UKDV) tracks 30 high-yielding UK companies that have held or increased their dividend for at least 10 consecutive years.

See our ETF Select 100    Discover more about ETFs

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