An Exchange Traded Funds FAQ - dummies

By David Stevenson

Here are answers to a few common questions that investors in the UK often pose as regards to ETPs and ETFs:

  • What is the difference between an exchange-traded fund and a unit trust? This is perhaps the basic issue for many private investors. Most of the index-tracking funds on offer are shares-based funds that are ‘listed’ on an exchange, and thus the acronym used to describe them starts with an E, as in exchange.

    That means you have to buy and sell an ETF through a stockbroker, who can deal in real time – although a bid–offer spread also exists between the asking and selling price. Many investors don’t have accounts with stockbrokers but use an adviser who may not even have access to a dealing platform.

    In this case, you probably have to use an index-tracking unit-trust fund or an open-ended investment company (OEIC) where the fund is structured in almost exactly the same way as an ETF but with dealing on a daily basis.

  • Is knowing the difference between the various acronyms (ETP, ETF, ETN and so on) important? Absolutely! Nearly all the most popular structures for stock exchange listed funds come under the umbrella description of ETPs, with the main difference being between the products structured as funds – ETFs – and the rest.

    The latter includes notes (ETNs), certificates and exchange-traded commodities (ETCs). Don’t think of these as being right or wrong, just different. For instance, ETNs are probably the only way of accessing many alternative assets, whereas most investors invest in ETFs.

  • Which is better – physical or synthetic tracking? In a synthetic ETF, the issuer tracks a major index but that return is in effect a form of IOU. In a physical fund, the managers own the share. Nothing’s right or wrong about each, you just need to understand the different risks.

  • Is counterparty risk a big problem? ETNs and certificates have an obvious risk – they’re IOUs by a large financial institution, a form of securitised derivative. But that risk can be overstated and blind investors to their opportunity.

    Two of the major ETF players in the UK are Lyxor and Deutsche DBX, owned in turn by national banking giants SG and Deutsche Bank. Both offer a huge range of funds, many at very low expense ratios – investors who ignore this range of funds must be concerned that the French and German governments would let these national champions go bust.

    Although possible, this eventuality is unlikely – and even if they did go bust, an additional set of protections is in place (including collateral) to protect the investor.

    The Financial Services Compensation Scheme (UK) doesn’t cover listed products (funds, notes and certificates). If you invest in ETFs, ETNs or ETCs, you do so at your own risk – the government isn’t going to bail you out! Note that no such protection exists in the US.

  • Stocklending activity – how much goes on and who benefits? Stocklending is a perfectly acceptable practice (many actively managed funds also engage in securities lending) and involves the stocks and bonds in a portfolio being lent out to a third party. Concerns include:

    • What happens if the borrower of shares in the fund goes bust?

    • How easy will it be to grab back and sell any collateral offered up by that borrower?

      But remember that stocklending is carefully managed and monitored. You need to make your own decision as to whether you’re happy with the procedures and collateral on offer.

  • How liquid is the ETF? ETFs have become insanely popular in Europe, with trading volumes exploding in recent years. But that liquidity can also be a curse as markets stress or liquidity seizes up.

    Market makers may choose to expand the bid–offer spread on lightly traded ETFs to unacceptable levels – these spikes in bid–offer spreads can also move around on an intraday trading basis. These excessive spreads also point to a bigger challenge – ETPs of all shapes and sizes are emerging in Europe, but that listing activity isn’t always translated into action on exchanges.

    Many European ETFs, for instance, boast low Average Daily Volume (ADV; the number of shares traded each day) figures and at times unattractive bid–ask spreads, which can nibble away at (or completely devour) your returns.

    Liquidity issues also show up in the difference between the asking and selling price: the bid–offer spread. In theory, this should be a matter of a few basis points at most; that is, a few hundredth of a percentage point.

    But in many ETFs, bid–offer spreads can shoot up to 1 per cent or more, resulting in higher costs. (The bid, or offer, price is the price a buyer is willing to pay for a security, and the ask price is the amount the seller is willing to accept. The bid–offer spread is the gap between the two.)

    Are ETFs the most tax-efficient route for my investment? In general, ETFs offer tax advantages over mutual funds because of the way they are structured and classified. Although exceptions do apply, you pay capital gains taxes on ETFs only after you sell your entire investment, unlike mutual funds, which incur taxes whenever the assets in the fund are sold.

    The tricky part is that many ETFs invest in foreign bonds and shares where the home government imposes a withholding tax – the US government, for instance, can claim as much as 30 per cent of any income paid out on its domestic shares and bonds. In the UK, dividends from non-UK dividends are subject to corporate taxes.

    Therefore, many ETFs sold to UK residents are issued in Ireland, where the withholding taxes can be reclaimed by the fund manager, allowing the investor in the UK to receive their dividend income gross.

    As a result, many investors needlessly worry about ETFs where the ultimate holding company appears to be based in Dublin, the Republic of Ireland. Their concern is that, although Ireland is covered by EU fund rules, the structure of the fund may be looked upon as opaque and something of a tax dodge.

    In reality, these offshore tax homes are a complicated way to deal with underlying fund administration problems based around tax on dividends and capital.

    Each fund and asset class varies enormously and so investigate fully the tax status of your ETF.