Well, well! I’s session number 50 – a nice little milestone. Today we’re going to be talking about Exchange Traded Funds.

I can imagine that just the title is filling you with great excitement, but sarcasm aside, don’t switch off, because ETFs are now a very important vehicle for investing and if you don’t know about them, you really should.

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As usual, after the main body of the show I’m going to look at the most recent reviews that have been left by listeners. I’ll also look at the news for the week (and it’s been a good week), and announce the next session topic.

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But first…

Sponsor Message

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Introduction

Exchange Traded Funds (henceforth to be called ETFs), and their cousins ETCs – Exchange Traded Commodities, and ETNs – Exchange Traded Notes, have only been around for 21 years. But there are now over 4,500 of them worldwide with more than US$2 Trillion invested. That’s a lot, that is.

Before we look specifically at what they are and how they work, we need to start by briefly explaining the difference between passive and active investing.

Active investing involves a fund manager making investments in selected assets, whether they be shares, bonds, commodities or whatever. His or her investment choices are made with the intention of beating the market, usually expressed as some form of benchmark.

Passive investing doesn’t even try to beat the market. Instead it seeks to replicate the performance of the market or benchmark as accurately as possible.

Why settle for just replicating – Isn’t that a bit defeatist? The main reason is that although an active manager will aim to beat the market, statistics show that most do not consistently achieve that. Many investors therefore prefer to avoid the risk of choosing a bad manager, and the extra cost of active funds, and instead opt to track the market they’re interested in.

The vast majority of Exchange Traded Products are passive instruments. With that in mind, let’s look at everything you need to know about these useful little products…

Everything you need to KNOW

1 – Exchange Traded Products come in different flavours

As I mentioned briefly just now, Exchange Traded Products is an umbrella term, covering Exchange Traded Funds, Commodities and Notes.

ETFs give access to things like equity indices, lie the FTSE100, commodity indices, fixed interest, money markets, private equity indices and the like

ETCs provide access to individual commodities like gold, oil, soft commodities like wheat and sugar, industrial metals like copper and zinc. They can also give access to baskets of commodities, where more than one individual commodity type is held and also to currency.

ETNs provided access to similar things but rather than the physical asset like gold or a share, they will give access to these markets using financial instruments like uncollateralised debt securities. Sounds like black magic to me!

They all have their place, but the latter of these, ETNs are, I believe, only for experienced investors.

2 – ETPs have five key characteristics

Even though ETPs can have several different forms above, they all share some important characteristics:

• They are listed on a stock exchange – This means that they act like a share, with their value changing throughout the day. This is as opposed to ordinary funds like OEICs and Unit Trusts whose prices are usually set once per day. You can always see how an ETP is doing by simply looking at its price at any given time, just like a share.
• They trade like shares – they are easy to buy and sell at any time during the day when the market is open, just like shares
• They are liquid assets – A liquid asset is easy to sell because there is a market for it. There are plenty of buyers and sellers for ETPs which makes them liquid – useful if you need to get your hands on your money quickly
• They track an underlying market or asset – They aim to provide the same return (before fees) as the asset or index they are tracking
• They are passive investments – and therefore a cost-effective way of getting access to a market or asset because there is no active manager to pay.

These characteristics make ETPs an attractive way to invest, in my view.

3 – ETPs are all about replication

The whole purpose of an ETP is to replicate or track its underlying market, asset or index. So a FTSE100 ETP is trying to replicate the performance of the FTSE100 over time. There are two ways an ETP can do this:

• Physical Replication  – the fund buys, holds and sells the actual underlying assets in the same weights as the index it is seeking to track. So our FTSE100 ETF will buy all 101 stocks in the FTSE100 in the same weights as the index and constantly adjust each day to replicate the index. Exchange Traded Commodities also use physical replication to actually buy the underlying asset. So a Physical Gold ETC will buy gold and store it in vaults. Some funds will use Full Replication and buy all the funds in the FTSE100, say, and others will use Sampling Replication where only a sample of the underlying assets are bought.
• Synthetic Replication – this method uses complex financial instruments to replicate the index, and may not buy any of the actual underlying asset. ETCs which are not investing in metals but for example in wheat or sugar will usually use Synthetic Replication because the difficulties in buying and storing vast amounts of these assets and transporting them is problematic. Words you hear when talking about synthetic replication are swaps and counterparties, all of which can be very confusing. The costs of Synthetic ETPs are often lower though as they don’t have many of the transaction costs associated with Physical Replication.

It’s important to understand that no ETP can track its index or underlying asset perfectly. The mere fact that there are costs involved means that an ETP will by definition underperform its underlying, even if only by a small margin. This margin is called a tracking error, and is an important margin of how well an ETP is working.

4 – Watch for the complexities

Ordinary investment funds can be straightforward ‘long-only’ funds which means the managers buy stock, hold on to it until it goes up and then sell it for profit. They can also be short funds, usually called hedge funds, which seek to profit from falls in the value of the shares they hold. There’s more about this in video Episode 288.

ETPs can work the same way in that it is possible to invest in short ETPs.

It is also possible to investing in ETPs which are leveraged, which simply means that they borrow money to invest. This can make things twice as good when markets rise, but twice as bad when they fall.

In short, ETPs can be simple, in the case of a fund holding physical assets like gold or easily-understandable assets like shares. Or they can be complex, such as when you get a short, leveraged Exchange Traded Product.

Summarise KNOW

So, here’s what we have learned so far:

#1 – ETPs come in different flavours

#2 – They have those five key characteristics

#3 – They’re all about replication, but that works in different ways, and

#4 – You need to watch out for the complexities

Knowing all this, what do we need to do with our new-found knowledge?

Everything you need to DO 

So let's deal with everything you need to DO if you’re going to invest in these vehicles

1 – When investing in ETPs, you need to understand what’s under the bonnet/hood

This doesn’t just apply to ETPs of course, but any investment. In recent years there have been a spate of failed investments, resulting in investors losing millions. Names like Arch Cru, Lifemark, ARM and Catalyst, Keydata – all of these were investments with unusual things under the bonnet which advisers didn’t understand (If they did, I don’t know why they would have sold them) and which wen belly-up leaving investors high and dry.

I’ve heard an argument that says something like: most people don’t understand how a car works, and yet they still get in and drive it, so why do investors ned to understand whats under the bonnet of an investment?

This is crap. One is the foundation of your future hopes and dreams, the determining factor as whether you’ll be able to live the life you want to lead. The other is a car, for crying out loud!

Fact is, it’s quite possible to get rich by investing in ordinary things like shares, bonds, property and the rest. Those who get sucked into esoteric investments are often greedy, trying to have their cake and eat it.

As we’ve seen, ETPs are many and varied and you need to understand the difference and make sure you’re investing in the right ones. So for example, if a client asks me for an investment in gold, I will only ever use a physical gold ETC. I don’t want one with complex financial instruments in it – I want to hold the damn gold!

If you’re starting out, definitely stick to the mainstream products and you shouldn’t go too far wrong. Providers of ETPs are iShares, ETF Securities and Lyxor among others.

2 – Use them for satellite holdings, rather than the core

Back in session 41 I talked about building an investment portfolio from scratch and I mentioned using passive, multi-asset funds to start with. This gives you a broad-basses foundation for your wealth in an off-the-shelf manner and doesn’t require too much input from you.

If you fancy a more hands on approach, then you could build your own portfolio using ETPs and other tracker funds. But I tend to stick to having the multi-asset core, and then adding to it around the side using ETPs. This is called a core/satellite approach.

So if a client has an established portfolio and then thinks they’ll have a punt on some gold, I’ll use a physical gold ETC like I said before. But if a client has nothing and asks to invest in gold, I’ll try to steer them away from that and build them a decent foundation first.

3 – Make sure  your platform of choice offers access to ETPs

ETPs are still relatively new, only being launched in the US in 1993. But still, that is 21 years, and you’d think that most platforms would offer access to them by now. But the reason many still don’t is that dirty old word – commission.

Until recently, many platforms worked by offering the funds of many different providers under one roof. You the investor would pay full retail price for the funds, and the platform would pocket a rebate commission, paid to them by the fund provider.

ETPs never paid this rebate – one of the reasons they are so low-cost – and so many platforms didn’t offer them. Now we’re in the new, more transparent world, you will have a charge for your platform and a charge for your chosen funds; all nice and clean.

Some platforms are being slow to add the new-fangled Exchange Traded Products though, so before you decide on which platform to build your wealth with, make sure they are offering a half-decent range of ETPs. You might not need them yet, but one day you will.

4 – Watch for UK Reporting Status

Many ETPs are domiciled offshore in places like Dublin, the Isle of Man or the Channel islands. This has tax benefits for the fund manager but can cause difficulties for the less-savvy investor.

The thing you want to look for when choosing any ETP or offshore fund is the UK Reporting Status. The option you want is a Yes, in other words, you want the fund to be a reporting fund. The difference is simple enough:

If the fund is a UK reporting fund, then any gains you make are taxed as Capital Gains.

If it is not, then any gains are tax as income, which is a higher rate.

It can be quit a stark difference. If you’re a higher rate taxpayer and you make a £50,000 gain, then taking off the annual capital gain allowance for the reporting fund, the tax on the gain would be £10,948.

But if you unwittingly opt for a non-UK reporting fund, the income tax would be £20,000.

If I were you, I would only use UK reporting funds, but if in any doubt talk to your accountant or financial planner

Summary

ETPs are useful things. They are modern, clean, low-cost method of investing in pretty much any asset class in the world, without the risk of choosing the wrong manager. They should be a part of any intelligently thought-through portfolio, and particularly a mature one. Don’t worry about them too much if you’re starting out, stick with the passive multi-asset funds we’ve talked about before, but if you’re expanding your horizons, take a good look at these important assets.

Any questions on any of that, then let me know in the comments section

Listener Question

Sheila called a couple of weeks ago and asked a question about buying non-UK shares. I missed the notification that she’d left the message, so Sheila – forgive the tardy reply here. Also I had to cut off your greeting as there was a lot of buzz on the recording, but no matter.

To buy non-UK shares you’ll either need a stockbroker, or a decent investment platform. Find out if yours will allow you to buy and sell these. There may be extra costs involved with  buying and selling overseas shares.

One thing you need to be aware of is exchange rate risk. Because currencies move against each other, it is quite possible to make a Euro gain, but convert that to a loss when you exchange the money back into sterling. There’s not much you can do about that. Fund managers use hedging techniques to offset this risk, but you need big bucks to do that, s you’ll have to take the extra risk on the chin.

You should be fine with the L’Oreal shares, as they’re a big company listed on a liquid market. But not all stock markets work as efficiently as the ones in the big western markets. For example I sometimes think that the Chinese stock markets more resemble gambling dens than efficient market systems. So I wouldn’t venture too far afield.

Also, be aware of the risks of investing in any one share, offshore or otherwise. If that company goes belly-up, you’ve potentially lost all your money, so don’t invest what you can’t afford to lose.

Hope that helps. Would love to get more questions from you all. I’ll either add them to the end of each show like this, or batch them together into one Q&A show. Depends on how many we get…

This week’s reviews

This is where I read out the reviews from iTunes – have you left yours?!

If you like what you hear on this podcast, please leave a rating or review on iTunes by going to meaningfulmoney.tv/iTunes just like Mr Ransley, Cesto23, Carl TW1, MissMoneyPocket, Tomp8519 and Baylisscat did this last week. This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings.

Glossary

Not sure this is adding anything – so I'm binning it!

News

Had the most amazing week last week in podcast terms. I had a record number of downloads for the week at 3,418. That’s nice enough, but that was 50% higher than any previous week. So far this week (Sun to Sat), it’s looking even better. I don’t know if I’ve been featured somewhere or what, but something must have happened to trigger such a massive increase practically overnight. If you know – let me know!

Static on the weight loss, but it’s been a good week and am hooping for good results next week.

Next Session Announcement

Next time we'll be talking about how to give money away. If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/feedback

I’m also hoping to get a phone call that I can record with friend of the show Justin Urquhart Stewart from Seven Investment Management. I want to pick his brains on what’s going on in Ukraine, and the impact that geopolitical events like this can have on investments. Depending on how long that is, it might be a whole show and that might end up being next week’s session

Outro

That's it for this session of the MM podcast, I hope it was helpful. Did I miss anything? Do you have any questions? If so, please leave them in the comments section below.

I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.