Archived article: Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
When it comes to exchange-traded funds (ETFs), many investors fall into a trap of simplifying them as “just passive funds” or misjudging their risks and costs. These funds are becoming increasingly popular in the UK, so it’s worth addressing some common misconceptions
1. ETFs are just plain vanilla passive funds
This is perhaps the most pervasive myth. While many ETFs track broad indices, not all do. There are actively managed ETFs, smart-beta ETFs, thematic ETFs, and single stock leveraged ETFs. Lumping them all together ignores the diversity of strategies, cost structures, and risk profiles which will appeal to different kinds of investors.
2. ETFs are always cheaper than actively managed funds
This is often true, but not universally so. Some niche or thematic ETFs have relatively high charges, sometimes in excess of active funds. Indeed some ETFs are now entirely active themselves. Low ongoing charges don’t guarantee performance, but fee differentials, even among passive options, can make a meaningful impact over time.
3. ETFs will perform better than other open-ended funds over the long term
What drives the returns of an ETF or a standard tracker fund will be the portfolio held within it and the charges. So, an ETF and an index fund tracking the same index and with the same charges should more or less deliver the same returns in the long run. The main difference the ETF brings to the table is that you can buy or sell it throughout the day, whereas index funds hold the same price during the day, so there might be a slight difference in the original cost. That means you may be able to time your entry and exit slightly better in an ETF, but then again, maybe not if you get your timing wrong. In any case if you’re invested over say, 20 years, the difference made by one-day market movements at the back and front end won’t make a huge amount of difference to your overall returns.
4. ETFs are always diversified
This very much depends on the index being tracked. Some indices, like the MSCI World Index, are composed of hundreds of stocks. Others only have a limited number of holdings, such as the MSCI Mexico Index which has 23 stocks, with 75% of the weight of the index falling into the ten biggest companies. Customised indices for thematic ETFs can also be pretty concentrated, and there are single stock and leveraged Exchange Traded Products which take concentration to the next level. If you buy a 3x Leveraged Tesla ETF, you essentially have 300% exposure to one company. These kinds of ETP are extremely risky, and some of these are classified as complex instruments, so can only be purchased by investors with the appropriate level of experience.
5. You can buy US-listed ETFs
The US stock market has the widest range of ETFs listed on it. However, UK investors can’t buy them because of regulations which require providers to issue Key Information Documents (KIDs) which comply with UK regulations. That said, there are loads of ETFs available to UK investors, many of them replicas of strategies trading in the US. The London Stock Exchange has more than 2,300 ETFs listed on the main market, so there’s plenty of choice.
Laith Khalaf: Head of Investment Analysis
Laith Khalaf is AJ Bell's Head of Investment Analysis. He joined the company in 2020 and continues to explore the world of personal investing, providing research and analysis to both AJ Bell customers and the...
