ETFs (Exchange Traded Funds) are listed on the stockmarket, they are mostly ‘passive’ funds, so their aim is to track the performance of a commodity or a particular index, rather than trying to beat the market, which is what an actively managed fund tries to do.
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vantage of an ETF over an actively managed fund, is that you are able to obtain a wide and diversified exposure to the market, on a very low cost basis.
Although they have increased in popularity, investors need to be aware of the pitfalls – as with any financial product, some ETFs are better than others.
ETF Tracking
As mentioned, the purpose of an ETF is to track an index. Therefore it would be wise for investors to compare the returns of the ETF against the returns of the index that is being tracked. Although the charges of an ETF are lower than most funds, charges still apply so it won’t track the index 100% – this is known as the tracking error.
In addition, different ETFs use different methods of tracking the market. The ETF may buy all of the shares in the chosen index (full replication), this is often the best approach if it can be done on a cost effective basis.
Partial replication, also known as optimisation, is where the manager buys a representative group of shares in an index, but this could lead to a greater tracking error.
The final method is where the ETF provider enters into a swap (a type of deal), with another party (known as a counterparty), this is known as a ‘synthetic’ ETF. The risks around this method of tracking are in relation to the counterparty, will the counterparty be able to honour the full agreed return, what if the counterparty goes bust?? Due to the risks around this, it is advisable that an individual looking to invest into an ETF takes independent financial advice.