Another popular option if you really want an easy life

Exchange-traded funds seem tricky but they are actually quite simple.

Even the world’s most famous active investor doesn’t think much of active investment. In a 2013 letter to shareholders, Warren Buffett revealed that, when he dies, he has asked trustees to invest 90 per cent of the money he will leave to his wife in a low-cost fund that tracks the S&P 500 index.

Exchange-traded funds (ETFs) are a fast-expanding category for investors going “passive”. They are traded on the stock exchange, have lower fees than other tracker funds and deliver exposure to a broad range of markets, from UK blue chips to emerging markets and commodities. There are 1,770 ETFs listed on the London Stock Exchange, more than three times the number five years ago. So are they for you?

Should I be investing in passive funds?
ETFs were conceived as cheap index-tracker funds. Increasingly, retail investors are asking whether actively managed funds justify their higher fees. According to the ratings agency S&P, over the past ten years, seven out of ten European or UK equity managers failed to beat their benchmark index; for US equity funds the number was nine out of ten. If you’ve been picking the best-performing fund managers, you probably feel they are worth their higher fees. If not, these numbers may make you feel queasy.

Are ETFs the only way to get passive exposure?
No. If you want passive exposure to the leading indices, such as the FTSE 100 or the S&P 500, you will have a range of traditional index-tracker funds from which to choose, sometimes at comparable costs. Those include unit trusts and investment trusts. Move away from the mainstream to emerging markets and ETFs are typically the cheapest and often the only passive game in town.

Are there other benefits to ETFs?
ETFs are more transparent than other index funds and are easier to follow than active managers, says Adam Laird, of Hargreaves Lansdown, the financial services company. In niche sectors such as emerging markets it can be hard to see what holdings a passive fund contains or what rules they use to select them. Managers are cagey about how they have assembled their portfolio because, in part, this is what they are charging for; active managers, similarly, tend not to broadcast their stock picks lest competitors copy them. Yet the prospectus of an ETF will provide full details of the underlying holdings.

Why are the fees so low?
Most ETFs provide retail investors with access to the leading stock-market indices for annual fees of less than 0.2 per cent. Aggressive pricing by providers is helping costs to fall further. A year ago BlackRock slashed the price of its flagship iShares FTSE 100 ETF from 0.4 per cent to 0.07 per cent, to undercut Vanguard’s fee of 0.09 per cent. Vanguard is the company Buffett advised his wife to use. Other big names, including Deutsche Bank and State Street, have been cutting their fees too.

Are ETFs only about equities?
Far from it. Exchange- traded commodities (ETCs) provide the easiest route to commodity ownership for ordinary investors and are also growing. Gold ETCs, in particular, have boomed with prices up 18 per cent this year. ETFs holding bonds are also gathering pace. Popular sectors include short-maturity bond funds and those tracking high yield, where the higher interest offered by less creditworthy companies appeals.

What are the risks?
While ETF fees are lower they include costs that you won’t find in conventional funds. You still have to buy the ETF through a stockbroker who will charge you a fee. Brokers also buy ETFs for less than they sell them so, in the unlikely event that you sell immediately, you will lose out there too. And beware of complex structures. In addition to the company providing the ETF, you may be dealing with a second, hidden “counterparty”, on whose solvency your investment depends.

Ben Gutteridge, the head of research at Brewin Dolphin, an investment management company, says: “You can address this hidden counterparty risk by always looking out for the UCITS [Undertakings for the Collective Investment of Transferable Securities] kite mark. This class of funds is governed by rules requiring multiple counterparties, making the chance of such a scenario negligible.”

THE PERFECT ETF PORTFOLIO
● FTSE 100
iShares FTSE 100
The UK’s oldest ETF and still one
of the best. This is a simple FTSE 100 tracker with a low fee of
0.07 per cent.
US Equities
iShares Core S&P 500

Europe’s largest ETF, tracking the S&P 500 index of the largest US companies.
Emerging markets
iShares Core MSCI Emerging Markets

The emerging markets ETF covering almost 2,000 companies, with fees of only 0.25 per cent.
Bonds
Lyxor ETF iBoxx £ Gilts
With interest rates and bond yields at historic lows, low-bond fund fees are appealing; Lyxor recently cut the fee on its UK gilt fund to 0.07 per cent.
ETF gold
Source Physical Gold
Invest in gold for an annual 0.29 per cent fee. It’s backed by bullion held in JPMorgan’s vaults and, unlike buying gold coins, you can wrap this (like all ETFs) in your stocks and shares Isa.