Invest around the world at low cost: Reasons to add ETFs to your investment portfolio
Sponsored by iShares and IG
Passive investing has come of age in recent years as more investors question the value that some costly active fund managers provide.
While market performance is outside of an investor’s control, the amount they pay is firmly in their hands and many are looking to lower cost alternatives offered by exchange traded funds (ETFs).
But why are more investors buying into ETFs and what can they do for you? We reveal five reasons to add ETFs to your portfolio.
ETFs offer the opportunity to invest around the world at a low cost and are growing in popularity
What is an ETF?
An ETF is a fund that follows a basket of investments that fit a defined index and strategy, rather than having a manager cherry-picking what he or she considers best.
Unlike index funds, ETFs are listed on a stockmarket such as the London Stock Exchange. You invest in the same way you buy and sell shares, purchasing a stake in the ETF.
From when the first ETF was launched in the 1990s in the US, the industry has grown to be worth $2.67trillion, offering access to markets around the world as well as exposure to commodities such as gold and oil.
An ETF’s performance will mimic that of the index. So if it goes up, so will your investment – similarly if it falls your investment will also drop.
Michael Gruener, co- head of EMEA sales for iShares, says: ‘ETFs are efficient from a pricing perspective, transparent as you know what you are investing in, and flexible as you can use them to buy and hold or actively trade.’
There are almost 6,000 ETFs listed worldwide, so why should you consider them for your portfolio?
Take advantage of low costs
Active funds charge fees based on the supposed expertise and skill provided by a manager and their team.
This means you end up paying for this expertise. Those charges will eat into your returns and the effect of that is magnified over time.
ETFs can keep their costs low as there is no fund manager to pay. According to data specialist Morningstar, the average total expense ratio for an equity ETF is 0.39 per cent.
Actual costs could be even cheaper, with some priced as low as 0.07 per cent.
This compares to the typical level of 1.25 per cent to 1.75 per cent for investment funds put forward by the Investment Association for the broadly similar ongoing charges measure.
Again actual costs could be lower and in a few cases closer to 0.6 per cent.
Lower charges mean that ultimately you will keep more of the returns.
If you do want to track a market, it is still worth comparing the cost of an ETF with an index tracker fund, some of these can carry lower overall once buying and selling fees are taken into account.
However, buying an ETF can be more flexible and a greater selection are becoming available. Meanwhile, they are priced throughout the day, whereas investment fund-style trackers are not.
According to iShares, the average cost of a core portfolio of ETFs, combining exposure to shares, bonds and different regions, is 0.19 per cent.
High costs can eat into your investments - and the effect is magnified over the long term
Regular pricing and transparency
As ETFs are listed on a stock exchange their pricing is regularly updated throughout the day and easy to find. Their share price should reflect the value of the assets they hold, although market supply and demand can lead to occasional small inconsistencies.
You will see that price whenever you want to buy or sell, unlike with an investment fund where the price is set just once a day.
Knowing how much you are paying means you can time your investment if you think you have an idea of when the best time to enter a particular market is. This is more useful for those trading to take advantage of short term price movements.
There is also more transparency than with a fund manager. If you are tracking the FTSE 100, for example, you can just check the index to see where your money is going. In comparison, actively managed funds often just reveal their top ten holdings.
Avoid performance anxiety
Fund managers must tell you that past performance is no guarantee of future returns, but they do like to use their statistics to promote their products.
These can often flatter the fund. However, there are often times when active managers have failed to beat their benchmark or the wider market.
Even if a fund manager beats its benchmark one year, there is no guarantee that will happen the next.
Research from Standard and Poors shows for the five years up to the end of 2015, 94 per cent of US active funds failed to beat the S&P500. Similarly, 89 per cent of global managers underperformed the S&P Global 1200.
In this situation you could have been better off with an ETF just tracking the index.
UK fund managers fare better but S&P Dow Jones Indices figures still show that 53 per cent of UK equity funds were outperformed by their benchmarks over five years.
Of course, there is no reason why you can’t mix both active funds and ETFs in a portfolio. In fact, many investors choose to use a blend of the two.
Performance anxiety: Picking active managers means trying to work out if you're backing a winner
Invest in different markets
Traditional funds tend to invest in either continental Europe, the US, UK or emerging markets.
Drill down into more specialist fields and you are likely to pay extra for an active manager.
However, there are ETFs that track more exotic markets such as Brazil, Eastern Europe, Taiwan, and even Korea.
An active fund would require the costs of a management team researching and scrutinising companies in these areas. But an ETF could give you cheaper access by simply following the performance of the country’s stockmarket.
A new breed of ETFs, known as smart beta, also target specific investing factors, such as value, quality or momentum. These use investing theory to create an index tilted towards a specific factor that they believe will outperform over time, for example value investing which targets the cheapest shares.
Pay less to hold investments
The most cost effective way to access ETFs is often through an DIY investing platform.
Holding your ETFs on a platform makes it easier to combine them with other investments and hold them in an Isa or Sipp.
Platforms are also now offering a wider range of ETFs as the market grows and since the Financial Conduct Authority removed commission payments from traditional investment funds to platforms in 2014.
Some platforms will allow investors to hold ETFs at a low cost, as they will only levy percentage-based annual fees on the amount you hold in funds. In some cases you can even hold ETFs for free.
You need to remember that ETFs will come with dealing costs similar to shares, however. On some platforms this will be the same as investment fund dealing charges, but on others the latter can be free.
If you want to build an ETF portfolio it is important to find a platform with a combination of low dealing fees and low annual charges that suits your investing behaviour.
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