Bank notes
A decade ago, it wouldn’t have been very easy to invest in the stock markets without the bother of choosing the stocks yourself or finding an active manager to do it for you.
You could have bought a unit trust that tracked a market. But it wouldn’t have been particularly cheap and it wouldn’t have been particularly easy to trade in or trade out. However, if you want to do the same today, the world is pretty much your oyster.
Exchange Traded Funds (ETFs) are an inexpensive and extremely simple way of investing in indices all over the world. You just choose where you want to put your money (from the Taiwanese and Brazilian stock markets to precious metals, biotechnology or high-yielding bonds) and buy an ETF that suits. There are around 2,500 and they can be bought and sold on the stock market at any time, just like ordinary shares. Better still, added to the convenience of investing like this, ETFs are usually very cheap to use. A traditional tracker fund can easily cost 1% a year of your assets in fees. But ETFs can come in at 0.25% or even less.
That’s the kind of thing that can make a huge difference to long-term returns. So it is no wonder that ETFs have become tremendously popular. In 2000 very few people had heard of them. Today the industry is managing more than $1.5trn worth of assets and is growing at 40% a year.
However, brilliant as they are in most ways, ETFs aren’t perfect. As is always the way in the financial industry, a good and simple idea has been corrupted by the launch of ever more expensive and complicated products. The original ones – which simply replicated indices by buying and holding all the securities in the index – have been added to by so-called synthetic or swap-based ETFs. These don’t actually hold the securities in the index they are supposed to track. Instead they use various derivatives to replicate their performance and sometimes even borrow money to enhance their performance. Sounds dangerous? That’s because it can be. As soon as you move into leverage or into anything connected to derivatives, you up your levels of risk.
Debt might help performance when things are going well. But when they are not, it will mean you lose more money than you might have otherwise. And derivatives? They bring in so called ‘counterparty risk’; the risk that the institution your ETF provider has done deals with will (like Lehman Brothers back in 2008) not be able to keep up its side of the bargain. ETFs should probably be a part of most modern portfolios – they are of mine. But if you start adding them to yours, stick to the original concept: buy the simple and cheap ones and ignore the rest.