A very smart way to play the exchanges, but not for the novices

An exchange traded fund is not a tracker, says Jenne Mannion. There are many advantages for wise and brave investors

When is a tracker not a tracker? When it is an exchange traded fund, or ETF. That is the new mantra of the stock market as shares maintain their recovery from the low point of last March. If you are a market bull, one of the cheapest and most flexible ways to capture stock-market growth is through ETFs, which in their short life have acquired a curiously unloved Cinderella status.

These new investment animals were introduced to the UK stock market four years ago by Barclays Global Investors (BGI), and do the same job as any unit trust or investment trust that replicates a stock market index. And you can hold ETFs within a self-select Isa, ensuring all capital gains are tax-free.

Mark Roberts, head of product strategy at BGI's iShares division, says that like a unit trust, an ETF is an open-ended vehicle, and units are created or redeemed as required to reflect the underlying value of the fund. But, like an investment trust, an ETF is also a listed share with an underlying portfolio of stocks.

Investment trusts do not issue or cancel their own shares as they are bought and sold, so the pressure of supply and demand is absorbed by the price going down or up. That does not apply to ETF units, the value of which is solely determined by the value of the portfolio they own.

The most popular ETF in the UK is the FTSE 100, which is listed on the London Stock Exchange and mirrors the performance of the FTSE 100 index of leading shares. BGI, through iShares, also offers ETFs invested in other equity and bond indices in Europe or the US. You can, for example, invest in an ETF that replicates the S&P index in the US. In the next few months BGI plans to launch an ETF that will track the UK's FTSE 250 mid cap index. But while ETFs compete with index-tracker funds, there is virtually no competition within the ETF market, because iShares is the only provider of these products in the UK. Previously, Merrill Lynch also offered ETFs - the Dow Jones Euro Stoxx 50 LDRS and dj Stoxx 50 LDRS - but these were taken over by BGI last September.

Another significant change was the decision by BGI last year to close its suite of dedicated sector funds. Until last August, iShares offered products that focused individually on technology, media, banks, and oil and gas, among others. BGI closed eight such sector funds, saying they were not a priority for UK investors and the group would focus on core markets.

The truth is that the three-year bear market and a weak appetite among investors for risk left ETFs on the shelf. Another reason their popularity has been muted is that many financial advisers do not recommend them to clients because they do not pay commission. But that should not blind investors to their advantages.

Ben Yearsley, an independent financial adviser at Hargreaves Lansdown, says the key benefits of ETFs are their flexibility and low annual management charges. The iFTSE 100 ETF is charges only 0.35 per cent a year, giving a total expense ratio (TER) of 0.4 per cent, while most equivalent FTSE 100 tracker unit trusts average 0.5 per cent. The one notable exception is Liontrust's Top 100 tracker, the cheapest unit trust tracker on the market, charging just 0.295 per cent.

Flexibility is another important feature of ETFs. "You can trade an ETF any time the market is open because an ETF is a share listed on a stock exchange," Mr Yearsley says. "Therefore, pricing is continuous through the day, and a unit trust is priced just once a day. This enables investors to take advantage of movements during the day and is particularly useful in volatile stock market conditions."

Patrick Connolly, an adviser at John Scott and Partners, says another advantage of ETFs is their ability to replicate a chosen index more closely than unit or investment trusts. "Many tracker funds have shown they are not capable of tracking accurately, especially those that do not use a full replication approach but instead merely take a sample," he says. "ETFs are better equipped to deliver the same performance."

Another advantage of ETFs is that you do not have to pay stamp duty on purchases, although there is a stockbroker's commission on the trade.

ETFs are a good alternative to index-tracking funds, but there is much debate about the merits of passive management versus active fund management. The ETFs are likely to appeal most to investors who do not want to pay the extra charges to have a fund manager actively manage their portfolio and possibly still underperform. Advocates of active fund management say stock picking, rather than tracking an index, is the best way to capture returns. Although this should work in theory, not all stock-picking managers make the right decisions, so they can do worse than a stock market over a given period. And most actively managed funds charge 1.5 per cent a year.

Mr Roberts says although active fund managers can at times provide stellar returns by outperforming the index and tracker funds by a handsome margin, only rarely are these returns consistent year after year. He adds: "On the other hand, an index-tracking fund should outperform the majority of active fund managers over the long term and will return at least as much as the market, after taking charges into account. Similarly, in times of falling markets, many active fund managers do worse than the index. A tracker fund will generally not fall further the index it tracks."

But most intermediaries prefer investors to opt for actively managed funds, especially when shares are forecast to rise only modestly. Mr Yearsley says: "ETFs are good products, but I expect stock markets will move broadly sideways to modestly upward. Under such conditions it is better to have a good manager picking the best stocks in the market, so you can focus on the winners and avoid the losers."

But Mr Yearsley accepts that, as a longer-term investment, ETFs can be a useful part of a broader strategy. An investor could have the iFTSE 100 as a core holding in a diversified UK portfolio, and use more volatile, higher-cost stock-picking funds as satellite investments to spice up performance. Averaged out, the risk might be the same as if you had bought a medium-risk fund with some correlation to the index, and total charges should be lower.

Experienced investors can also use ETFs to take advantage of short-term movements in markets, but Mr Connolly warns novices not to attempt this because of the inherent risks.

FACT FILE - EXCHANGE TRADED FUNDS

ETFS can be bought through most major stockbrokers. They will charge you commission, but using an online broker will keep this to a minimum.

Recommended stockbrokers for trading ETFs include Comdirect, online brokers include the Share Centre, and Redmayne Bentley. You can also buy actively managed funds that hold ETFs as their underlying shares.

David Franklin, a fund manager at Christows, last year launched the first unit trusts that use ETFs rather than conventional equities.

He says UK investors who want to buy ETFs direct have fewer creative options now than they had before the closure of sector funds late last year. Private investors can still access ETFs that replicate major global markets. Although the iFTSE 100 is the most popular ETF, Mr Franklin believes it offers little opportunity.

"Amid the recovery of global stock markets over the past 11 months, the FTSE 100 has been one of the weakest performers because this index is heavily laden with defensive stocks such as oils and pharmaceuticals.

"These stocks will not perform well in a bull market that focuses on growth opportunities. Our funds are not invested in the FTSE 100 index."

Mr Franklin says investors are better to invest in ETFs that track the European indices. Options available through iShares include the Euro 100, Eurotop 100 and DJ (Dow Jones) Euro Stoxx 50 ETFs. iShares Euro 100 tracks the 100 biggest companies on the Continent, and Eurotop 100 is pan-European so it includes UK companies such as BP and HSBC in the top 100. The EuroStoxx 50 concentrates on 50 companies in Europe.

"European markets have done so much better than the FTSE 100 and I expect that relative performance to continue," Mr Franklin says. "While the pan European ETF does include oils, the exposure to this sector is diluted."

He recommends investors avoid the iShares S&P 500 at present because of the weakening dollar. He says: "The S&P 500 index has performed well, but the declining currency means that even if the market continues to perform well, UK investors do not stand to make significant gains."

Unlike UK investors, Mr Franklin has access to ETFs listed throughout the world and will buy and sell ETFs according to which market he believes are likely to perform.

Minimum investment is £1,000 lump sum or £50 per month and these funds are available as an Isa.