Exchange-traded funds continue to flourish, despite the recession

Investors seeking better returns as interest rates on bank savings have fallen are looking to the stock market – and growing numbers are moving into exchange-traded funds.

They are collective investments that sit somewhere between an investment trust and an index tracker fund. Significantly, they allow investors to get exposure to a range of stock market indices, companies or commodities in a single trade.

William Rhind, head of UK sales at ETF Securities, says: "You can trade them just as easily as you can trade shares in BP, through a broker and online. All you need is a trading account and the fund's ID number."

Jonathan Hill, a certified financial planner at Milford & Dormor Solicitors in Chard, Somerset, says: "ETFs are invaluable for the plain vanilla part of clients' portfolios. We tend to use them instead of other types of index tracker, for instance, because of their price and transparency."

Barclays Global Investors' iShares, which Barclays has just agreed to sell to CVC Capital Partners, is the largest provider of ETFs in Europe, with £32.6bn of assets under management.

The other players in the London market are Lyxor Asset Management, a division of Société Générale, Deutsche Bank's db x-trackers, Invesco PowerShares and ETF Securities.

While ETFs are like other collective funds in many ways, they are unlike unit trusts, for which only one price a day is quoted, because their price changes throughout the day, just like the price of a share.

They also differ from investment trusts, which can trade at a discount or premium to the underlying value of the assets that are held in the trust, while ETFs generally trade close to the value of their assets.

Like an index tracker fund, they have no active manager, making them cheap to run. But, unlike an ordinary share-based index tracker, there is no stamp duty to pay.

Like shares, you buy ETFs through a stockbroker – including an online broker – so there will be a dealing fee involved, typically £10-£15. You will be quoted a different price depending on whether you are buying or selling: the spread. But, unlike shares and unit trusts, the spread will be small.

William Rhind says: "The beauty of ETFs is spreads are typically narrow – as tight as 0.15 per cent – in contrast to other shares and in complete contrast to unit trusts, where spreads can be huge."

There are also no upfront fees or redemption charges. Unlike unit trusts or open-ended investment companies (OEICs), where a separate fee is charged.

Rhind adds: "If you bought an ETF at a certain price and nothing happened in the market for year, the only effect you would see 365 days later would be a decay in the price of 0.3 or 0.4 per cent, to reflect the costing structure."

When ETFs first came to Britain, the choice was restricted. Now the five issuers between them offer a wide range: 78 ETFs based on developed market equity indices; 21 fixed income-based ETFs; 41 ETFs tracking emerging markets indices; 53 ETFs covering industrial sectors or specific asset classes, such as property, private equity or commodities, and seven "style" ETFs that focus on specific investment approaches, such as small caps or companies with a record of strong dividend payments.

Last month, iShares launched seven new funds on the stock exchange in response to demand for more funds exposed to bond markets. Barbara-Ann King, head of investments at Barclays Stockbrokers, says: "It is encouraging that clients are using ETFs. They are attractive to investors who are looking to actively diversify their portfolio while being able to take advantage of different markets and sectors."

One of the reasons for the growing popularity of ETFs is that they give access to investment areas that were formerly only open to institutional and professional investors. You can now venture into highly specialised funds – with an associated degree of risk – to suit your investment objectives.

Six weeks ago Deutsche Bank launched the world's first ETF based on actual hedge funds (rather than hedge fund strategies) and linked to the db Hedge Fund Index.

Db x-trackers' Thorsten Michalik says: "UK investors have been slower to pick up on the attractions of ETFs compared to other European regions, perhaps because most investors already included an index tracker in their portfolio, but this is changing."

Adrian Lowcock, senior investment adviser at IFA Bestinvest, says: "One of the big advantages of ETFs is holding investments that involve physical assets, such as gold or oil. You do not want to try to buy these outright yourself, and ETFs provide a good way of minimising the costs involved."

Another way to make money out of ETFs – and one that has been successful in recent months – is "shorting" an index, or making money as markets fall.

Michalik says: "In the past 12 months of bad news and volatile markets, UK investors have been seeking returns in new places. We've seen particular interest in our short ETFs – many investors have seen fantastic returns on these products – and also in emerging markets, where the ability to trade daily, no matter the political or local market situation (it can often be difficult to take money out of emerging markets), is an attractive benefit."

Where to start?

Investment analyst Morningstar says: "The most logical place to start for UK investors is with the UK marketplace; after all, your portfolio should, to a certain extent, reflect the economic realities of your country of residence."

Once you have decided what sectors you want to invest in, you should check on how the fund works. Two similar-sounding ETFs may be very different in their underlying investment approach because of the way they are structured.

Anyone who has invested in a conventional stock market tracker knows the way a fund replicates a particular index is crucial to performance. While one tracker may hold every share in a particular index, incurring tax and dealing costs, another will use representative sampling – buying a sample of the players – or even "synthetic replication", using a device known as an "index swap". This all but eliminates tracking error, but it comes at a price.

The chief executive of iShares, Europe, Rory Tobin, points out that the price the investor pays for synthetic replication is not just in monetary terms, but "counterparty risk".

The "swap", he says, is simply a promise by one bank – or several in multi-party swaps – to pay a sum equivalent to the return on an index. The instruments that make up the swap will very likely not actually be the constituents of the index that it is guaranteeing, but simply an investment that will give the same return as that index. "In an extreme situation you could have a UK corporate bond ETF, but the underlying fund composition is a basket of Japanese equities," he says.

This is fine until the ETF provider goes bust, when you might be surprised to find what you have actually invested in. In the wake of the Northern Rock collapse, investors are increasingly worried about where they stand with regard to compensation.

Michalik says: "ETFs are regulated, authorised investments offering the comfort of protection, which investment in an ordinary stock would not."

As with shares – or indeed any investment – you cannot get compensation simply for poor performance. The sale of ETFs is rarely advised, although you would be covered for mis-selling and poor advice.

Where there is a case of default by a manager there could be some unravelling to do. If the fund was based simply on securities, since the assets in the fund are held in trust, the fund would simply be handed over to a new manager.

There may, however, be more complicated instruments involved, particularly with swap-based trackers. Under UCITS III regulations (European rules on Undertakings for Collective Investment in Transferable Securities), exposure by European swap-based ETFs to the risk that the swap-provider will default is capped at 10 per cent of the ETF's net asset value. If you are concerned about counterparty default risk, it is as well to do your research.

You should be able to find out how a fund is structured on the provider's website along with past performance data. You also need to check how the fees impact on performance. Look at the figure for the total expense ratio (TER).

Another point to look out for is how much of an index is taken up by a particular share. William Rhind says: "UCITS funds will have concentration limits. The more off-piste you go, the less the spread of companies becomes ideal, and the more ETFs become a vehicle to gain access to markets."

What are ETFs? The pros and cons

ETFs are collective investments similar to tracker funds, but they have several advantages – and disadvantages.

Advantages

*You can buy exposure to an entire sector or index with one trade.

*Prices are quoted throughout the day.

*They are passive funds – there is no manager, which makes them cheap.

*Spreads – the difference between buying and selling prices – are narrow.

*There are no entry or redemption charges.

*You trade them like ordinary shares.

*They allow entry to certain market sectors where no other mutual funds exist.

*They allow entry to sectors such as property, gold or private equity which would be unaffordable via direct investment.

Disadvantages

*If your chosen fund is using "swap replication" you need to be aware of the risk.

*Some niche ETFs may be illiquid.

*Beware of funds with similar names such as FTSE-100 or "Brics" – they are unlikely to be identical and could be vastly different, so make sure you choose the right one for your needs.