Pros and cons of exchange-traded funds

In the short term, however, Mr Blake said investors need to pay for dealing charges as well as account for the bid/offer-spread that traditional funds don’t have.

“Regular savers who invest a certain amount every month might find traditional funds more advantageous. But their flexibility and cost-efficiency could make ETFs a sensible choice for many long-term investors.”

According to Morningstar’s European passive fund analyst team, the advantages of ETFs are:

1) They are known to have low annual expenses, especially compared with traditional actively-managed funds.

2) There is no minimum investment requirements, meaning investors can buy a single ETF or many.

3) Investors can ccess a vast range of different investments, including bond indices, foreign market indices, and commodities.

4) ETFs trade on the stock exchange and can therefore be bought and sold throughout the trading day, unlike Oeics and unit trusts which can generally be bought and sold only once a day.

The disadvantages are:

1) In general, ETFs do not give investors the opportunity to outperform the market.

2) There are many different kinds of ETFs and ETPs, and some may not be suitable for all individual investors.

3) Since ETFs trade on the stock exchange, it can be tempting to trade ETFs frequently, especially when markets are volatile, which would accumulate trading costs.

Mr Thompson says ETFs offer investors the same opportunities as an institutional investor and at the same price as an institutional investor. However, like any investment Mr Thompson states there are risks that advisers should be aware of.

“Due to the nature of some of the markets that ETFs can provide exposure too, the benchmark index tracked may be complex and can be volatile, especially in some more remote emerging markets, or in the case of commodities, which expose investors to a liquidity risk.

“Currency risk can be an issue too if the ETF is denominated in a currency different to that of the benchmark index they are tracking. In this case, exchange rate fluctuations can have a negative or positive effect on the returns generated by the ETF.”

The last and perhaps most talked about risk is counterparty risk, according to Mr Thompson.

“Counterparty risk can be borne from the use of a swap or securities lending programme in the ETF. For a synthetic ETF using a swap, it is with the investment bank who issues the swap. If the bank was to default, they would be unable to pay the performance of the index to the fund.

“As such, the value of the fund is based purely on the physical assets owned by the fund. This is why Ucits regulation states that an ETF can never be more than 10 per cent exposed to the swap counterparty.”

In the case of securities lending, Mr Thompson pointed out the risk is that the hedge fund or financial institution is unable to give back the stock it borrows, and as such the fund falls back on the collateral that the borrower has put up as security.

Mr Thompson said the key for both physical and synthetic ETFs is for advisers to take the time to understand the policies.

“If they stock lend, who do they lend to, how much do they lend and what do they take as security? For a synthetic ETF; what does the ETF hold as collateral, is it owned by the ETF or the investment bank, and what is the minimum value it can be?

“A further point that advisers should be aware of is that many platforms aggregate ETF orders and trade only once a day. This means that advisers cannot access the intraday liquidity, and the cost can be relatively high if you are the only one trading the ETF that day.”