Etfs and Etcs

Exchange Traded Funds

Exchange Traded Funds or ETFs are simply an investment fund that tracks the performance of an index. This could be something familiar like the FTSE 100 – the top 100 companies quoted on the London Stock Exchange – or something more unusual like pork bellies. The range of ETFs available has widened considerably since they were first introduced in 2000.

They can be bought and sold like normal shares during trading hours through a stockbroker with the added advantage that since you are spreading your investments over an entire index you are spreading your risk. The value of your ETF will rise or fall in line with the index it is tracking. Though the ETF may not entirely replicate the index as it may not hold everything in the index, it will broadly follow its movements. This tracking error is more pronounced with more exotic ETFs. Unlike other collective investments, ETFs typically do not have a minimum amount you have to invest. 

They are known as passive funds because they do not have a manager choosing the company shares, bonds or commodities to put in them.  (Just to confuse matters, there are now some actively managed ETFs available from the States.) Actively managed funds, such as unit trusts and mutual funds, have a manager – and team of analysts - running them.

Exchange Traded Commodities or Currencies

These are simply commodity or currency ETFs.  The first commodity ETFs – now known as ETCs - followed the price of gold and silver and actually held these precious metals in the form of bars.

Since then other ETCs have been launched which don't hold the physical commodity. Instead many of them hold futures contracts based on the forward price of the commodity or derivatives. These expose investors to greater risks and do not track the changes in price as accurately.

The range of commodities has increased since the early days to include other predious or industrial metals, energy and soft commodities such as wheat, sugar and coffee as well as funds offering a basket of commodities.

Currency ETFs are also known as ETCs.  These will track the foreign exchange rate of various currencies such as the pound, the euro or the US dollar. Some currency ETFs are more complex as they trade a basket of currencies in relation to either a single currency or a group of other currencies.

ETCs don't pay interest or dividends to investors.

What is the cost?

Since you're not paying for the expertise of a manger, the costs of ETFs are lower. There's no initial charge and their annual charges – typically 0.20% to 0.75% - are the lowest of all collective investment schemes according to the London Stock Exchange. They also don't attract stamp duty – unlike share trading.

You buy them through a stock broker so there will be the usual broker's fee to pay. As with any investment, you will have to look at your capital gains tax (CGT) liability, but you can avoid tax by putting them in your stocks and shares Isa or pension fund. Those ETFs which hold non-UK companies are issued outside the UK to avoid UK corporation tax on dividends.

ETFs don't pay dividends but dividends are reinvested into the fund.

What are the risks?

ETFs and ETCs are not directly covered by the Financial Services Compensation Scheme. But the investment performance of any fund is not covered by the FSCS. It is the advice given to you which is covered not the product.

Like any investment, you can lose money if the index falls in price. But you also need to check the type of ETF you are buying. The Financial Services Authority is concerned that some investors do not understand what they are getting into and that there are too many exotic ETFs being launched.

Physical ETFs which own the assets they are tracking such as shares, bonds, precious metals or oil are considered safer than synthetic funds. These use complicated financial instruments such as derivatives and forward contracts to replicate the performance of the index they are tracking.

The risk here is whether the financial institution offering these complex instruments can meet their commitments – this is known as counterparty risk. If the bank or institution went bust, their contracts could become worthless. However, the ETF provider can hold other assets belonging to the bank as collateral to reduce the risk.

As with other types of investment, if you can't understand what you are buying, don't buy it.