The fact only a quarter (27%) of fund managers beat the market in 2022 has led many investors to look at low-cost tracker funds. Instead of trying to outperform the market, why not simply mirror what it does and not worry about a fund manager making good or bad decisions.

Exchange-traded funds or ETFs are a form of tracker fund. Their charges are typically a lot lower than an actively managed fund because there is no fund manager to pay. Instead, the ETFs track a specific index whose make-up is based on rules that a computer can manage at little cost. This might be a basket of large shares trading in a certain part of the world or ones which pay generous dividends.

The appeal of ETFs can be illustrated by a single product. For an ongoing charge of just 0.05%, compared with a rough average of around 1% for actively managed funds, investors can use Amundi Prime Global ETF (PRIW) to gain exposure to more than 1,500 stocks across developed markets. This example of diversification at such a low cost is what’s driven growth in the ETF market since the first such instrument, tracking the FTSE 100 index of UK shares, was listed in London in 2000.

What is an ETF?

An exchange-traded fund or ETF is a fund which trades on a stock exchange. Like any other fund, they diversify an investor’s money across a range of underlying holdings contained within an index thus spreading the risk.

Because they are traded on the stock market, they can be dealt online at a live market price throughout the day, just like regular shares. ETFs are also exempt from stamp duty.

In the intervening 20-plus years the market has expanded hugely, and investors can now invest in a wide variety of markets using ETFs including bonds, property, commodities and even specific themes and investment styles.

In this article we look at the different options and highlight some of the cheapest products. In a separate article, we select some ETFs to create a diversified portfolio from scratch. 

WAYS TO INVEST IN THE UK, US AND OTHER KEY MARKETS

For many people ETFs are a useful way of tracking the big domestic and overseas indices. A starting point for lots of UK investors will be the FTSE 100 and the iShares Core FTSE 100 (ISF) is both the longest standing UK ETF and one of the most widely held. It charges just 0.07%.

Competition in this area of the market means there isn’t a huge amount to choose between the different ETFs when it comes to cost. Though because of the big fees ETF providers must pay the index providers like FTSE and MSCI, products not tracking mainstream indices can be cheaper.

Lyxor Core UK Equity All Cap (LCUK) follows the Morningstar UK NR index – targeting the top 97% of stocks on the UK market by size – and its charges are even lower than the iShares FTSE 100 product at 0.04%. L&G UK Equity UCITS ETF (LGUK) has ongoing charges of 0.05% and tracks the Solactive Core United Kingdom Large & Mid Cap index. It is excluded from our table due to only having £69 million in assets.

For the most part the underlying holdings and performance of these alternative indices will be broadly like their more established counterparts.

Some investors may prefer to play UK stocks through an ETF which tracks the FTSE 250. This mid-cap index has a more domestic focus than the FTSE 100 and has performed better over the long run. There is a clear difference in cost, with Vanguard FTSE 250 (VMID) the cheapest.

For the US, most mainstream ETF products are focused on the S&P 500 index. From a diversification perspective this makes sense. The alternative US indices include the Dow Jones Industrial Average where the weighting of stocks – how much the movement of an individual share influences the direction of the wider index – is done according to share price rather than market value.

The Dow’s composition is also opaque with constituents qualifying by being ‘leaders of the US economy’ and it has a smaller allocation to the big tech companies than the S&P 500. The other big US index is the Nasdaq, which is even more dominated by technology, so the S&P 500 provides a middle ground between the two.

Why a UK investor cannot buy US-listed ETFs

While it is easy to buy US-listed shares, the same does not apply to US-listed ETFs.

A UK investor cannot buy a US-listed ETF because the products lack the type of information documents required under European rules.

There are ETFs tracking Europe-wide indices and you can also use ETFs to access emerging markets though fees are higher, particularly if you want to target individual markets thanks to the more limited liquidity and accessibility of stocks in the developing world.

Why size is important with ETFs

It’s worth bearing in mind when looking at an ETF with only limited assets (such as less than £100 million) that the product is at risk of being closed if it cannot attract more interest.

These sub-scale ETFs may also have more limited liquidity which leads to a larger spread between the price at which you can buy and sell.

If you are holding an ETF for the long term this might not make a huge difference, however you may well want to rebalance your portfolio if the proportion of stocks to other asset classes has moved above or below your targeted level and here small differences in the cost of trading can add up over time.

THEMES, SECTORS AND OTHER AREAS

There are ETFs which provide exposure to specific sectors, trends and themes as well as other asset classes like bonds.

When it comes to thematic ETFs, there is less competition, so costs tend to be higher. The size of an ETF is also more of a consideration as some products attract limited assets because of their niche appeal. If an ETF cannot gain scale, such as having assets worth more than £100 million, there runs the risk of it being shut down by the provider.

The performance of thematic ETFs has been mixed and there is an argument that a more nuanced, active approach can be a better way of capturing returns from long-term trends. Also, by the time a trend has entered the mainstream to the extent that ETF providers have launched products to tap into it, many of the obvious stocks positioned to harness it may have already rallied.

There are lots of ETFs with an ESG (environmental, social and governance) focus. Some are deliberately geared towards themes in this area while others track versions of existing indices which have been screened using sustainability criteria.

iShares’ range of thematic ETFs are some of the largest, addressing some of the risks around fund size, and include iShares Automation & Robotics (RBOT), iShares Digital Security (LOCK) and iShares Global Clean Energy (INRG).

How do you get income from an ETFs?

ETFs are normally set up for either income or accumulation. The ‘inc’ or income version of ETFs pay out distributions to holders as cash. ‘Acc’ or accumulation ETFs effectively reinvest the dividends for you. So, you need to make sure you buy the right version of the ETF if you want to receive the income as cash.

Some ETFs won’t offer a choice of income or accumulation versions of their fund. If there is no choice, it typically means any dividends will be paid out in cash.

iShares Automation & Robotics is, for example, considerably cheaper than L&G ROBO Global Robotics and Automation (ROBG) with an ongoing charge of 0.4% compared with 0.8% for the latter product. The five-year return for the iShares product is also better at 40.7% compared with 31.7% for the L&G ETF.

Sector-based ETFs often track broad industry categories and typically they don’t follow UK stock market groupings but are more likely to be global, US or regional sectors.

ETFs have been a useful way for ordinary investors to access the bond market, something it is difficult to do directly. Most of the products in this space provide exposure to baskets of government bonds or investment-grade corporate bonds.

There is also a range of exchange-traded products which track the price of individual commodities and sometimes a basket of them. Instruments offering exposure to gold are particularly popular. Real estate ETFs track stocks with exposure to this sector rather than investing directly in the properties themselves.

STYLES

It is possible to use ETFs to capture different investment styles or factors. Arguably these products blur the line between active and passive management.

Dividend ETFs which would appeal to income investors are more established. There are ETFs which track baskets of high-yielding stocks such as iShares UK Dividend (IUKD) and others that focus on dividend growth like SPDR S&P Global Dividend Aristocrats (SPDR).

Increasingly there are ETFs which are growth or value-focused and some which include stocks with share price momentum, or businesses with attributes which make them higher quality.

There are also several multi-factor products which select investments based on a range of different factors. iShares Edge MSCI World Multifactor (FSWD), for example, tracks firms in developed markets selected according to value, momentum, quality and size.

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