When we first started planning to invest in ETFs three years ago they were little understood or used in the UK. Many pension funds had decided it was best to index most of their equity investment but they tended to do it through unit funds that did a reasonable job of tracking the indices.
We liked the liquidity and lower costs of ETFs. Like Investment trusts, they have a quote and trade all the time the Stock market is open. Unit trusts have more restricted dealing times and dates. Like Unit trusts, the manager of the ETF can create or destroy shares or units, limiting the danger of the shares selling at a discount to the underlying value of their holdings. Investment trusts often sell at a substantial discount to their holdings. ETFs seemed to give us the best of both worlds.
As we studied them we discovered that the larger and older funds tracking the main world indices were able to get very close to perfect tracking after all costs and expenses. That after all, is what we are looking for. As we have built up portfolios of ETFs, more and more investors in the UK have come to appreciate their advantages and also bought. There has also been a big build up in the number, types and styles of such funds.
Like all successful things, ETFs also have their detractors. It is perhaps important to remind people from time to time of the realities. ETFs do not exempt a holder from paying the tax they would otherwise have to pay on similar investments not held through an ETF. A UK taxpayer has to pay income tax and capital gains tax. ETFs, like other funds and portfolios, can attract both types of tax. An investor needs to understand the tax status of the fund and his holding, or to take advice on it. Broadly, if a UK taxpayer buys a Reporting Status ETF they will pay income tax on the dividend and capital gains on the gain, but it needs to be checked out.
An ETF does not exempt an investor from the risks of the type of asset or market he or she is seeking exposure to. The whole point of the ETF is to capture the performance and therefore the risk of the underlying investment. Nor does an ETF exempt you from usual fund risks. Like all investment funds and portfolios, the manager of the fund has to buy and sell investments in accordance with the agreed aims of the fund, and the custodian and auditors have to check they have the assets and they are properly protected in case of trouble. ETFs are usually sponsored by large and strong companies, and have their own custodian and Trust arrangements to secure the assets. In each case these matters do need checking. Things could still go wrong in extreme conditions if those responsible broke the rules. No UK-listed ETF got into trouble during the very troubled times in markets in 2008, which was a good live stress test.
We are most concerned about the development of what we term complex ETFs. A simple ETF would, for example, track a major recognised index by using one of the normal replication methods and providing a high level of collateral as security for investors. This means your losses and gains are limited to losses and gains on that index in normal conditions. A complex ETF may be more like a structured product, with gearing and leverage, using options and other financial products to create a specified return. The more complexity there is the less we like the fund. We avoid ETFs which go short, gear or otherwise introduce leverage into their dealings.
We think it is difficult enough and risky enough deciding whether to be in shares at all or bonds at all or property at all. We do not want to gear our bet, as this would increase the losses if we were wrong. Good investors need humility in the face of markets, as well as good nerves and the ability to come to an intelligent decision about risk.