Hey, and welcome to another episode of Informed Decisions!
This time around we are taking a look under the bonnet of Exchange Traded Funds (ETFs) in Ireland and determining how they may or may not be something you want to get behind the wheel of as part of your 'investment portfolio'.
ETFs are well documented at this stage, having grown in popularity for investors over recent years. They now estimate that ETFs account for 25% of all stock market transactions (in the US anyway - Ireland is a little behind those guys!). Whether you do or don't know about them there is no doubt they are popular and more and more of us regular folk are asking about them here in Ireland!
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Why Are ETFs So Popular?
While we have yet to share an episode on Active versus Passive investing, ETFs are typically managed on a Passive basis, meaning there is no Fund Manager transacting and monitoring it, they are therefore generally a cheaper form of investment than buying individual shares or retail investment funds. In addition, the majority of investors investing in ETFs have done so in the past 8 years, in which there have been many years of double digit annual growth in most of the world's markets, which are replicated by the world's most popular ETFs!!
What Exactly Is An ETF?
I have yet to hear it actually explained this way but it is a Fund which is traded on the Stock Exchange, hence the name, Exchange Traded Funds! They are a form of what is called 'Exchange Traded Product'.... these ETPs are officially defined as open-ended investments listed on 'the exchange' in different countries and traded in the same way as shares.
They are passive investments aiming to replicate the performance of a given market, generally by tracking an underlying benchmark index. ETPs may also be referred to as Exchange Traded Vehicles (ETV)....! Boom, we have ETFs, ETPs, and now ETVs!!! If an ETF is a form of an ETV what the bloomin 'ell is an ETF so!? Let's ask the following question.
How Does Buying An ETF Compare To Buying A Share?
If you buy a share in a company, you are buying a piece of that company, as small as it may be! Say you bought 1 share in Bank Of Ireland today, 1 share will cost you €7.20. You will own 1 billionth of the company, a small portion, but you will own it! If BOI succeeds as a profitable organisation and other investors want to buy it it's demand will increase as will the value of the company, that share will increase in value. If it tanks, then so will the value of your investment!
If you buy an ETF, you are typically buying into a much much greater pool of companies. You are still buying a physical unit (more on that in a while!). For example one of the most popular providers of ETFs is iShares, and their World Equity ETFs will typically invest in over 1000 companies.....you are buying a slice of all those. Even more minuscule than your share of BOI, but so what! You get access to the performance of this large group of companies.
Just as with Shares all ETFs are traded on a stock exchange, they are not some online or back-alley item sold from a suitcase! Typically you can buy and sell them really quickly (on the day) so this makes them 'liquid' if you need to get your hands on the money. And just as with shares they track the underlying market or companies, meaning you should get the same rate of growth or loss as if buying that group of shares directly (which would beyond impractical and expensive to do!). There are many other differences, indeed between buying an ETF and buying a retail investment product, which we will cover in a future episode.
Can I Only Track Share Prices?
No! If you were so inclined (and many people are when it comes to building portfolios) you can also buy into Commodities such as Grain, Gas, Oil, Solar, & Wind energy, Sugar and Metals such as Gold, Silver etc etc....the list is I believe endless!! By definition when you are buying into Commodities via ETFs, they are called ETCs! (so we now have ETP, ETF, ETV and ETC!!).
Are There Different Types of ETFs?
Yep! There are 2 main types, Synthetic and Physical. A physical ETF, as the name suggests, will buy and own the relevant shares in the relevant group of companies under that ETF. It is therefore transparent and easy to understand. It can however result in higher costs and therefore a higher Annual Management Charge for you to pay, but you may consider that worth the money. It is usually easy to spot from a provider's ETF prospectus whether it is a Physical or Synthetic one....
A synthetic ETF is one where the provider will not purchase portions of the companies directly, but will purchase contracts which are essentially IOUs ('Swaps') from other institutions in order to try replicate the returns of the group of shares ('Index') in question. This does open up the risk of those providers not being able to honour these 'swaps' and thereby 'counter-party' risk comes into play on Synthetic ETFs. However, recent European regulation (UCITS III) has forbidden any provider having more than 10% of their ETF exposed to these IOUs, ensuring that in the unlikely event that all the IOUs in an ETF we to be defaulted on the investors would be out of pocket max 10% of their investment.
As well as the 2 types mentioned above, there are also 2 different ways in which ETFs are managed. Passive management will mean that the provider set up the ETF, sells units in it and does not alter the make-up of the fund. It simply tracks the ups and downs of the index it is designed to track.
On the other hand an Active ETF will mean the provider is buying and selling individual elements of the ETF on an on-going basis, in an effort to have their fund outperform the index, essentially to beat a passive fund which is tracking the same index.
What is The Tax Treatment of ETFs?
Any regulated investment which gives you a return will be subject to tax of some form or another, there is just no avoiding that! With ETFs it is no different. And this is the single biggest challenge with ETFs currently. Depending on whether the ETF you hold is based (domiciled) in Ireland, EU, non-EU or USA will determine how you should make a tax return to Revenue on any gains or dividends you might receive. This is one we will cover separately because it is so meaty, but suffice it to say you need to have your eyes wide open before taking any action to purchase ETFs, again another reason to have a competent individual assist you on these.
How Can I Invest in ETFs?
As we have hopefully explained already, you can purchase ETFs on the stock exchange, in the same manner as you would buy a share. The annual management charge on ETFs themselves are typically very low in comparison to typical retail funds, e.g 0.2% as opposed to 1.5% average. Depending on whether you purchase the ETF through a broker, an online platform or via your Financial Advisor there may be additional management fees involved. It is advised to consider what value you are getting when looking at this. Many people like to try and DIY their investments, purchasing swathes of shares or ETFs......this is fine provided you know what volatitlity you are exposing yourself to, and are confident you won't try and sell or rejig them yourself when the values fall by 20% in a couple of years! That is where it can pay handsomely to have a competent Financial Coach to steer you away from making those costly decisions.
ETFs offer a very cost effective way to get access to the potential long term growth of large stock markets, among other underlying assets. The tax treatment of them can be favourable. However, without trying to sound like a master of doom it is so so important that we are aware of exactly what we are investing in, how any gains will be treated, and ultimately what is the end goal!
Looking forward to sharing information on the tax treatment of them in a near future episode! Thanks so much for reading....
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