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Exchange Traded Funds

By Portugal team
This article is published on: 25th August 2023

Difficult times
With high levels of inflation and relatively low rates of returns on cash deposits, it is important to make sure your money is working hard for you.

In order to do this, investors will look to “real” investments i.e. assets that are expected to grow above the rate of inflation over the longer term – the main contenders are shares, bonds and property.

Make your money work harder
Whilst you can purchase individual investments direct, most investors choose to invest through a collective investment where you pool your money with other investors into a larger pot and appoint a fund manager to run this pot for you – in doing so, your combined value is larger and you can spread your investments much more widely which reduces risk. For example, the Vanguard LifeStrategy fund has approximately 22,000 underlying holdings.

‘Active’ versus ‘passive’ management
Active investors appoint a fund manager such as Fidelity or BlackRock to run the fund on their behalf and pay the manager a fee, typically between 1-2% per annum.

The alternative is to simply buy a basket of investments through a ‘tracker’ or passive fund – in this way, your fund will simply grow in line with the performance of the investments within the basket and do not have the personal involvement (and cost) of a fund manager overseeing the fund.

Examples of common trackers are those that mirror the S&P500 or FTSE100 indices, which are the largest companies trading on the US and UK stock markets respectively.

More money in your pocket with ETFs
ETFs are tracker funds that trade on a stock market and the major advantage is the extremely low fees, with annual charges on some ETFs as low as 0.01%. The savings in fees compared with active fund managers can make a substantial difference to the value of your investments over time.

As ETFs are traded in real-time on a stock exchange, they can be accessed quickly, with low costs and they offer access to a wide range of investments, from shares, gold and commodities to AI and environmental funds.

Exchange Traded Funds

The devil is in the detail
Whilst Exchange Traded Funds certainly have a place in a well-diversified portfolio, there are important considerations when selecting them.

Tracking error – as the sole job of the ETF is to follow the index it is tracking; you must ensure it is following the market accurately. If it fails to track the market it could result in underperformance, and this can be more costly than the fee saving on the management fee.

Skewed risk – be careful that your portfolio is sufficiently diversified e.g. you may think that the S&P 500 is a highly diversified basket because you have 500 different underlying investments but the top 10 holdings make up around 35% of the value of the 500. The risk is very skewed to the big tech firms such as Google, Apple and Meta.

Another example of skewed risk is the MSCI World Index tracker. Although ‘world’ would suggest a globally diversified portfolio around 2/3rd is invested in the US alone.

Counterparty risk – there are different ways of tracking the market. The most secure is “physical replication” whereby the tracker simply holds the underlying investments of the index it tracks i.e. if you buy a FTSE 100 tracker, you will simply hold the 100 shares that make up that index.

The other main way is “synthetic replication” which means the index is tracked by using a complicated financial product supplied by another financial institution. In this situation, you have to think about the additional risk of that counter-party’s financial strength.

Other important points to have clear knowledge of are:

  • The size of the fund
  • The ETF’s domicile status
  • The ETF’s tax residence
  • Income treatment
  • Currency of the ETF

In short, although Exchange Traded Funds and tracker investments are simple in principle, there are important nuances of which to be aware, especially when considering cross-border investment.

As always, when investing your hard-earned money, take guidance from a professional.

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