UK ETFs: How to Get Started

Ten years ago ETFs practically didn't exist. Now, they're an increasing popular - and practical - product for retail investors.

ETFs are instruments which track an investment - whether that's an index, commodity, or currency.  They are traded like shares, and like listed shares, can be held in an ISA or SIPP. Because they are not actively managed, you're not at risk of a fund manager making an unsuccessful market call, like Neil Woodford's recent switch out of BP and Royal Dutch Shell B.  into Glaxosmithkline and Astrazeneca (Of course, if he gets it right, you don't get the upside, either.)

 They also have lower costs than actively managed funds. For instance an iShares corporate bond ETF is available with a Total Expenses Ratio (TER) of 0.20 % a year [ref] Morningstar guide to ETFs, http://www.morningstar.co.uk/uk/news/article.aspx?lang=en-GB&articleid=49140&categoryid=240 [/ref] . That compares to traditional funds with typical charges of 1 to 1.5% - even on some passive tracker funds.

 And by the way, ETFs are a perfectly viable option for income investors. Unlike options, another way to trade indices, ETFs pay out a dividend based on the dividends paid by their index constituents. For instance IDVY (iShares DJ Euro STOXX Select Dividend) pays a distribution yield of 3.51% - not market-beating, but quite interesting compared to bank interest rates. 

 So far, so simple. You could just buy a FTSE 100 ETF, or a FTSE All Share ETF, and you've got your market exposure. In theory, a passive investor could create a pension portfolio entirely out of a selection of equity index ETFs and a couple of fixed income ETFs, and that would offer diversification - though it would never beat the market.

 There's a vast choice of ETFs available to the UK investor. When ETFs began, they focused on equity indices. However, new product areas have been added to the basket over time; commodity ETFs have been a particularly fast growth sector recently. Some commodites stocks are geared, meaning you get double the underlying performance of the commodity - definitely one for the risk taker, but don't put your whole portfolio in them! There are also fixed income ETFs, currency ETFs, and sector or theme based ETFs such as the iShares FTSE/Macquarie Global Infrastructure 100 ETF (INFR), which offers international exposure to transport and utilities stocks. There are even short ETFs which allow you to place a bet against the market.

 There are a few gaps. There are not really enough sector ETFs available to UK investors, particularly when you consider the plethora of sector and thematic ETFs available to US punters. For instance I've been looking for some exposure to the pharmaceutical and healthcare sectors outside the UK (having already stocked up on big yielders Glaxosmithkline and Astrazeneca ); there are a couple of interesting US quoted ETFs, but nothing in the UK, where the next best thing seems to be the Finsbury Worldwide Pharmaceutical Trust (Finsbury Worldwide Pharma ).  But it's got a 1.18% TER according to the Association of Investment Trusts [ref] AIC Press release, 6 March 2008: http://www.theaic.co.uk/Press-centre/CHARGES-CONTINUE-TO-FALL-IN-CONVENTIONAL-INVESTMENT-COMPANY-SECTOR-ACCORDING-TO-AIC-RESEARCH/ [/ref] .

 Using ETFs can help cut down on the amount of research you have to do. For instance if you want to invest in technology, but you don't feel particularly confident in your ability to analyse the industry, an ETF allows you to take that 'big picture' investment decision without having to decide whether Cisco is a better investment right now than Microsoft. Equally, rather than screening stocks for yield, and researching all of them, you might consider the iShares FTSE UK Dividend Plus (IUKD), which has a distribution yield of 4.06% and selects approximately 50 out of the top 250 stocks on the London market by forecast yield. (Equally, you could check out the list of its constituents [ref] iShares: IUKD holdings: http://uk.ishares.com/en/rc/funds/IUKD/holdings [/ref] and use that as your basis for further research. I also enjoy scouring some of the 'thematic' ETF holdings lists to see if there are interesting investment ideas hidden there.)

 ETFs do have a few disadvantages. It can be difficult to find information on ETFs; your best bet is the ETF providers' pages, for instance iShares at http://uk.ishares.com, but of course they only cover a subset of the market. Most stock screening sites don't have ETF details, so you can't easily ask which ETFs are yielding above 4%, for instance.

 Besides which, different brokers seem to have different coverage of ETFs. Some of the smartest ETFs are listed on Stuttgart - Deutsche Boerse has done very well out of ETFs, even though it only listed them for the first time in 2001 - which presents difficulties in dealing.

 ETFs have benefited from investors fleeing actively managed funds which have disappointed; there's a common perception that ETFs 'do what it says on the tin'. But you need to look under the bonnet and read the detail of how the ETF is invested; don't trust the label. Some global ETFs offer very different exposures to emerging markets, for instance; they may also track the index in different ways, which some do by full replication (buying every single stock in the index at the right weighting), others by optimisation (working out which stocks drive the index as a whole, using a complex set of algorithms, and buying those). That can create differences in performance, so two 'index tracking' ETFs might diverge significantly [ref] Seeking Alpha, ETF Investment Risks: http://seekingalpha.com/article/80486-etf-investment-risks [/ref] .

 ETFs lend themselves to a number of uses. For instance, you might use ETFs to provide an element of diversification in your portfolio. Suppose you have two small, high growth companies you want to invest in, but you also want exposure to broad market trends and don't want your portfolio too skewed to the high risk end. The old way to manage this was to put that part of your money in a unit trust, and invest a small part of your portfolio with your broker. Now, you can put all the money with the broker, buy the two growth companies, and then put the rest of the money into a FTSE tracker ETF.

 You need to make sure your ETF is really providing you with diversification, though. For instance,  I hold British Land, Hammerson, and Land Securities - nice big liquid stocks providing me with some income, and exposure to a commercial property upturn in the UK. I could get IUKP - but why? 47% of this ETF is invested in those three stocks [ref] iShares product details: http://uk.ishares.com/en/rc/funds/IUKP/holdings [/ref] . Instead, perhaps I should consider just holding IUKP, and then add some spice with smaller companies in the property sector which I think have greater exposure to the upturn.

Another possible use for ETFs is sector rotation. For instance, right now I'm looking for defensives to lock in gains I made with a modestly aggressive strategy of buying miners earlier this year. I'm not impressed by what's available on the UK market - the water stocks have a massive political risk coming up, and could cut dividends, there's National Grid, Centrica, Scottish & Southern Energy, and that's pretty much your lot. A couple of ETFs offer attractive opportunities for infrastructure investment - there's INFR, and also an emerging markets infrstructure play, IEMI.

ETFs also offer a short-cut to international exposure. If you're an active stock market investor, it's quite likely you have higher than optimal exposure to the UK market. With ETFs, you can provide your portfolio with exposure to selected international markets, such as the BRIC economies -for instance through iShares FTSE BRIC 50 (BRIC). At the same time you could consider either international equity index ETFs, or currency ETFs, to provide your portfolio with a currency hedge.

As with any shares, you'll want to check the liquidity and spread before buying. While many ETFs offer a low cost and highly liquid investment method, some have wide spreads, which could offset the normal cost advantages. (I must admit that I far prefer the trading process - one mouse click and it's sold, at a transparent market price - to the rather cludgy process of trading in an OEIC, where you have to place an order for a daily (if you're lucky! Sometimes only once a week) trade, struck at a price you can't foresee, with funds arriving in your account some time later.)

It's perhaps not surprising with all these advantages that ETFs have become increasingly popular - despite the fact that few financial advisers recommend them (perhaps because OEICs pay better commission) and they have a relatively low media profile. According to Credit Suisse, ETFs now account for 25% of all US market trading, up from 15% last year [ref] Financial Times, 29 April 2009: http://www.ft.com/cms/s/0/6e89a514-34e9-11de-940a-00144feabdc0.html?nclick_check=1 [/ref] . It's definitely feels like time to check them out.