Summary 

• The ETFs track the behavior and movement of commodities, sectors, indexes, or any other assets.
• The ETF categories may be classified into bond ETFs, industry ETFs, commodity ETFs, currency ETFs and inverse ETFs.
• ETFs provide the most convenient and cost-efficient way to invest in the UK stock market.

An ETF or Exchange Traded Fund is a basket of marketable securities that can be bought or sold like regular stocks on stock exchanges. The ETFs track the behavior and movement of commodities, sectors, indexes, or any other assets. They provide a diversified exposure to the market by offering a wide variety of bonds and shares to invest in with just one product. This has drastically transformed the stock market investments in terms of cost efficiency and exposure to a range of asset classes with utmost ease.

The working of ETFs is very similar to mutual funds, with the exception being that they are listed on the stock market unlike mutual funds. Additionally, they can be traded 24x7 in real time unlike other funds which are tradable only once per day. This helps in easily rebalancing the portfolio, that too very quickly. The ETF categories may be classified into bond ETFs, industry ETFs, commodity ETFs, currency ETFs and inverse ETFs etc.

Advent of ETFs

ETFs have been comparatively new to the market and were introduced only in 1990s. They have been accessible to UK investors since 2000. ETFs have rapidly grown from just one fund in 1993 (the S&P 500 SPDR) to 102 funds in 2002, and as of May 2020, over 7,100 ETFS were being traded across the globe (Source: ETFGI research). Some of the major ETF providers in the United Kingdom include Vanguard, iShares, ETF Securities, db-X trackers, and Lyxor etc.

A major proportion of ETFs are passive investments and trace the performance of the underlying assets. This makes these ETFs less expensive due to less broker fees. Although ETFs are low-priced as compared to regular funds, they often have an OCF (ongoing charges figure) which is a low going fees. Also, stockbroker fees may need to be paid as ETFs are traded in the stock market. On some low-cost ETFs, trading with no commission is offered by certain brokers, which further minimises the cost for the investors. The ETFs that are passively managed save both time and cost, but some ETFs have to be managed actively, and thus have a comparatively higher expense ratio as the portfolio managers have a greater involvement in the selection and active management of the funds with the aim to perform better than the market. For example, Vanguard FTSE 100 UCITS ETF which tracks the FTSE 100 index has an ongoing charge of only 0.09%, while on the other hand, the funds that are actively managed generally charge around 1-1.5%, as per the UK Government’s Money Advice Service.

There are basically two kinds of ETFs: physical ETFs and synthetic ETFs. Physical ETFs or fully replicating ETFs invest directly in the assets they track and imitate their movements. If it is tracking the FTSE 100 index, the investments will be made in the shares of FTSE 100 companies, while in case of a gold ETF the investments will be made in gold bullion. While investing in an ETF, it is important to note that the investor is buying a stake in the ETF, and not the underlying asset or the indices that ETF is tracking.

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Alternatively, synthetic ETFs are more complicated. They work on contracts with investment banks, which pledge to pay equivalent returns as the index or underlying investments that the ETFs are tracking. This is done via purchase of a kind of derivate instrument called Swaps. These ETFs give exposure to otherwise inaccessible markets, like stock markets not allowing any foreign investments or perishable commodities markets, in exchange of a fee. Both physical and synthetic ETFs can be bought and sold via stockbrokers.

ETFs provide the most convenient and cost-efficient way to invest in the UK stock market. There are 13 ETFs tracking four indices on the UK stock market, with an annual total expense ratio (TER) of 0.04% p.a. - 0.33% p.a. Eight of these ETFs track the FTSE 100 index, two of them track the MSCI UK index, two other track the FTSE All-Share index, and the remaining one tracks the Morningstar UK index. Considering the 1-year return, some of top ETFs in UK are SPDR FTSE UK All Share UCITS ETF, Lyxor Core Morningstar UK NT (DR) UCITS ETF – Dist, and Vanguard FTSE 100 UCITS ETF Distributing etc. While considering the total expense ratio, some of the top UK ETFs are Lyxor Core Morningstar UK NT (DR) UCITS ETF – Dist, HSBC FTSE 100 UCITS ETF GBP, and iShares Core FTSE 100 UCITS ETF (Dist) etc.

ETFs can be bought just like shares, mainly through online broker or fund platform. The investors may place their specific orders with their brokerage account, and the brokers in turn buy the shares from sellers in the market. The shares of the chosen ETFs are then transferred into your account. ETFs may also be traded via spread bets and CDFs (Contract for Difference), in addition to share dealing platforms. ETFs work with Authorised Participants or Market Makers, which are specialist firms that support seamless trading of ETFs during market hours. A majority of ETFs can be held in an investment ISA, which is a tax efficient account to shield your returns from income and capital gains tax. It should first be confirmed if the ETF provider is eligible for ISAs.

Another similar tax efficient way is to break up your total allowance into investment, cash, innovative finance, and a lifetime ISA. There may be certain obstacles faced by the investors if they don’t have an ISA or SIPP and the ETFs are registered outside the UK. These problems will be more significant for investors who are higher rate taxpayers because of having excess reportable income.