A masterclass episode by www.ExpatMoneyChannel.com

1. MASTERCLASS
EXCHANGE TRADED FUNDS
Sunday, 28 March 2010

2. 1) WHAT ARE EXCHANGE TRADED FUNDS (ETFs)?
At their most basic level, Exchange Traded Funds, or
ETFs are a basket of shares that make up a particular
stock market index, such as the FTSE 100 or Dow Jones.
So, for example you could buy a Dow Jones ETF which
will give you exposure to all the shares that comprise
the Dow Jones Index. Or you could buy a Commodities
ETF that gives you exposure to all the shares in an index
that tracks the commodities sector.
It is therefore an easy and cost effective way of getting
exposure to a particular sector of the market, whether it
is a country or an industry.
1 basket of shares = 1 ETF
1 ETF = 1 share
Sunday, 28 March 2010

3. 2) HOW DO THEY WORK?
If you like they are a cross between a fund and a share.
Like a hybrid rose, they offer the best parts of two
different species. Each ETF holds lots of different shares
(like a fund) but it trades like a share and so can be
bought and sold on the stock market at any point in the
day in exactly the same way as other shares.
The price of an ETF is determined by forces of supply
and demand and although occasionally their price may
move above or below the current price, there is a
mechanism that generally prevents the funds from
trading at prices way above or below their market value
for a sustained period of times.
You cannot sell the underlying shares contained in the
ETF fund.
Sunday, 28 March 2010

4. 3) HOW CAN YOU MAKE MONEY OUT OF ETFs?
This is based on the same principle as any investment -
you buy at a certain price in the expectation it will rise
in the future. So if you think the UK Dow Jones is
going to rise then you buy the Dow Jones ETF and
wait for the price to go up. In addition, the ETF pays all
the dividends from the Index stocks and twice a year.
You can also buy ETFs to protect your portfolio as, like
shares, you can use options (perhaps another
Masterclass!) to profit from a falling market.
However, most private investors use them to access
markets they feel are going to rise in the medium to
long term, but are otherwise difficult and/or costly to
access.
Sunday, 28 March 2010

5. 4) ARE THEY EXPENSIVE?
In terms of buying and holding they are much cheaper
than a fund as they don’t need a fund manager to
actively manage them. They simply replicate the basket
of shares in a particular index.
If you are holding them for the long term then they
will work out cheaper than a fund or even a tracker
fund. However, if you bought and sold on a frequent
basis then the dealing charges could easily mount up.
Typical costs will be trading costs of approximately £7-
£15. There is no initial charge and annual management
charges are around the 0.2%-0.5% level, as opposed to
1% for a tracker fund and 3%-5% for an actively
managed fund.
Sunday, 28 March 2010

6. 5) HOW DO THEY DIFFER FROM TRACKER FUNDS?
They essentially do the same job - in that both
tracker funds and ETFs track a particular index
or combination of indices, i.e. as they contain
the same shares as the index they will mirror
the rises - and falls - of an index.
However, as a tracker fund has associated fund
management costs, albeit less so than an actively
managed fund, an ETF can therefore be a
cheaper and more flexible option as outlined on
slide 5.
Sunday, 28 March 2010

7. 6) ARE THEY RISKY?
As with any choice you need to balance your investments with
the level of risk you are comfortable with. So if you are want to
invest in a particular market sector such as telecommunications
or media, then an ETF is a good way to do this as it offsets the
risk of buying a single stock or company in that sector. They are
also very transparent and investors can monitor the ETF and
its underlying shares online on a daily basis.
However, one risk is that their flexibility may tempt some
investors to trade more frequently than they would normally
do with a more restrictive investment vehicle.
Frequent dealing means you are open to increasing costs as
well as altering the make up of your portfolio more than you
anticipate.
Also, like any investment there is also a currency risk. So if you
opt for an exotic ETF then remember to factor in the effect of
the underlying currency.
Sunday, 28 March 2010

8. 8) HOW CAN I INCORPORATE THEM INTO MY INVESTMENT PLAN
Think of it as mixing the ingredients for a cake! You may
wish to reduce the sugar or add chocolate in order to
change the taste.
ETFs offer similar possibilities for your portfolio. Their
flexibility means they are ideal for diversifying or altering the
style of your portfolio. For example, as you can easily get
access to the performance of an entire index or asset class
through one ETF you may wish to hold a basket of blue chip
UK stocks via an FTSE 100 ETF in order to tilt your
portfolio towards large cap UK companies. Or you may like
to add a bit of excitement to an otherwise conservative
portfolio by buying a commodities ETF.
In addition, ETFs allow you to access a basket of shares in
emerging market countries where you would normally find it
difficult to access investment opportunities.
Sunday, 28 March 2010

9. 9) HOW CAN I BUY ETFs AND WHERE CAN I FIND THEM?
You can only buy ETFs via a stockbroker or independent
financial adviser. You can find them listed on major
stock markets and share trading sites. They either have
the letters ETF at the end or they may have branded
names such as iShares.
As well as being listed on major stockmarkets, many
ETFs are listed in offshore financial centres. For
example, iShares (formerly Barclays and now owned by
BlackRock) are domiciled in Dublin. So if you are a non-
resident you can take advantage of any tax advantages
afforded by the offshore fund regime.
Sunday, 28 March 2010

10. TO SUMMARISE
- ETFs are a cross between a fund and a share
- They offer diversification through exposure to a basket of shares
- They are cost effective
- They are cheaper than managed funds
- They are transparent
Sunday, 28 March 2010