The use of exchange-traded funds (ETFs) has expanded rapidly in recent years, with global ETF assets now topping US$5trn (£3.8trn), according to data from ETFGI.
And it is not just large institutional investors who have benefited from this growth. The rise of the ETF has been positive for investors of all sizes, bringing the advantages of low cost and broad diversification, and ultimately, better outcomes.
Low-cost ETFs are winning converts among investors who have traditionally favoured individual stocks and high-cost mutual funds. This suggests investors are increasingly recognising the negative impact of high fees on long-term returns.
Among advisers, access to ETFs through platforms in the UK remains a challenge, although this is improving and growing numbers of advisers are showing an interest in using ETFs to help clients build their portfolios, access a range of exposures at low cost, and reach their financial goals.
Index funds have been a huge force for change in investing, helping people reach their goals more quickly by reducing their costs and allowing them to keep more of their returns.
ETFs represent the next stage of the indexing revolution globally, and they are increasingly becoming the vehicle of choice for investors’ index exposure. The EDHEC European ETF Survey 2017 suggests that 71 per cent of European investors use them frequently for achieving broad market exposure.
Key points
- Low cost ETFs are becoming popular with investors
- ETFs can be bought and sold on the stock exchange
- ETFs can provide diversification
Many advisers are now discovering how the disruptive power of ETFs can benefit their clients. They can be accessed at any time across a range of exchanges by investors anywhere in the world, and they are effectively democratising investing by providing institutions, advisers, and retail investors with the same investment tools at the same costs.
What are ETFs and how can investors use them?
ETFs combine the features of mutual funds with those of individual shares.
Like a traditional mutual fund, an ETF offers the opportunity to invest in a portfolio of securities, such as stocks or bonds.
As with a mutual fund, each share of an ETF represents an undivided interest in the underlying assets. They also offer professional management, so you do not have to keep track of every security your fund owns.
However, ETFs are different in that they can be traded throughout the day on an exchange at a market-determined price. Mutual funds, in contrast, are bought and sold directly through the fund company at the fund's net asset value (NAV) at the end of each trading day.
Most ETFs use an indexing approach. They are built so that their value can be expected to move in line with the indices they seek to track. For example, a 2 per cent rise or fall in an index should result in approximately a 2 per cent rise or fall for an ETF that tracks that index (before fees and expenses).
ETFs offer a number of benefits, including low costs, liquidity, and diversification.
ETFs generally have lower ongoing charges figures (OCFs) than mutual funds, and index-based ETFs generally cost less than actively managed funds and ETFs. Lower costs mean more of a fund's returns go to the investor. However, when trading ETFs, investors incur transaction costs such as broker commissions, so investors should always weigh the full costs of investing.
In terms of liquidity, ETFs are traded on stock exchanges, so they can be bought and sold any time the exchange is open, even if the underlying market is closed. For example, a UK investor can buy a Japanese equity ETF during UK trading hours when the Japanese market is closed.
Diversification
ETFs can also provide diversification. An ETF that tracks an index might contain hundreds or thousands of securities – more than many actively managed funds and far more than a typical portfolio of individual securities. Broad diversification can help offset the risks associated with any one security or market segment.
ETFs also provide full transparency on their underlying investments. As a result, investors and advisers are kept informed about their constituents, performance versus the benchmark, and costs on a regular basis.
ETFs can be used to implement a variety of short and long-term investment strategies.
At a strategic level, they can help clients construct their core portfolio allocation, as they offer fast, precise and cost-effective access to a broad variety of assets and sub-asset classes.
Active and passive combinations, combining index ETFs and low-cost actively managed funds for diversification and the opportunity for outperformance, are possible, too.
There are a number of other ways advisers can make the most of ETFs. Their flexibility can help investors with liquidity and transition management. They also allow for rebalancing and tactical adjustments, among other uses.
With margins likely to come under increasing pressure over the coming years, the role of ETFs in constructing investors’ portfolios will only become more important.
Given their versatility and their benefits for clients, we believe they will continue to gain traction within the adviser community, not only as flexible building blocks that allow them to deliver high-quality portfolios to their clients, but also with the low costs that can help maintain their margins.
Neil Cowell is head of UK intermediary distribution at Vanguard
