An exchange traded fund (ETF) is a low cost index tracking fund that aims to track the performance of a particular benchmark. The main difference between an ETF and a “traditional” unit trust/OEICs index tracker fund is that ETFs can be bought and sold at any time during the normal trading day i.e. they can be traded in real time. Unit trusts/OEICs usually have a single forward pricing point.

ETFs offer some advantages over traditional investment funds:

• Simplicity & flexibility
  ETFs provide the investor with the ability to buy into (or sell out of) an entire asset class with a single trade.

• Transparency
  As most ETFs track an index and the index’s composition is published periodically, investors can determine exactly the investment exposure of the ETF.

• Liquidity
  ETFs are listed on a stock market and are traded in exactly the same manner as any other share.

• Cost efficiency
  ETFs do not have any entry or exit charges and annual fees are low although they will be subject to dealing costs.

How do ETFs track the benchmark?
There are broadly three methods that ETFs can use in order to capture the returns of a particular index:

• Full replication
  The ETF will own every share in the index in the same proportion as the index. Any changes in the index will be reflected in the ETF. Although replication may seem like the best method this is not always the case. For example where an index has a large number of constituents, owning each of them may become expensive (if not impossible), particularly if the stocks in question are small and traded infrequently.

• Stratified replication
  Most of the shares of an index are owned to achieve a close approximation of the return of the index.  This is predominantly used to replicate benchmarks with many constituents or where the cost of ownership is prohibitively high.

• Synthetic replication
  This is where the ETF holds a pool of assets equivalent in value to most of the ETF value. The ETF will also hold “swaps” or “contracts for difference” issued by a counterparty.  The counterparty will promise to give the return of the underlying index in exchange for the return of the pool of assets posted as collateral.

What are the drawbacks?
Along with the traditional risks associated with investing in assets “where prices can fall as well as rise”, there is an additional risk. As with any investment involving a counterparty, there is a risk that the counterparty will not be able to meet their commitments or obligations. In the case of ETFs this risk is somewhat offset by the fact that there is collateral involved in the swap.

When do we use ETFs?
Our portfolios currently include 3 ETFs, which allows us to gain exposure to asset classes not currently very well served by existing index tracking funds.

To find out more about how we use ETFs in our investment portfolios please give us a call on 0845 345 3536 or send an email to info@proposito.co.uk