Are you using ETFs properly?

Are you using ETFs properly?
Five tips to get the most out of ETFs
Dan Lane
May 15, 2021

Investors poured more money into stock ETFs in the first four months of 2021 than they did over the entirety of 2020.

That’s according to Morningstar, who reported ETF inflows of $253.5bn to the end of April versus $231.8bn for the whole of 2021.

ETFs are clearly grabbing investors’ attention.

And it’s not just new money sloshing in. This year’s TrackInsight Global ETF Survey found 57% of respondents were using ETFs to replace actively-managed mutual funds. That’s up 39% on 2020’s findings.

But digging into the reasons behind it all might reveal a few areas investors need to understand a bit better to ensure they’re making the right choice for their portfolios.

Why invest in ETFs?

84% of investors taking part in TrackInsight’s survey said low costs associated with ETFs were the biggest reason they hopped aboard. 77% pointed to diversification as a key driver too.

For those familiar with the rise of ETFs and their ongoing battle with the active fund industry, these top reasons and the percentages they carry might not be a huge surprise.

But, as the ETF industry evolves, seasoned investors risk letting these assumptions go out of date if they don’t keep up with exactly how it’s all changing.

Commenting on the survey results, TrackInsight chief exec Jean-René Giraud said, "Active strategies, thematics and new assets like SPACs and cryptocurrencies have helped redefine what ETFs are and are also paving the way for future growth.”

Whether you are an ETF whizz or are just looking into them for the first time, here are five things to keep in mind that might challenge the conventional wisdom.

Read more:

- What is an ETF?

- How to invest in ETFs

1. Not all ETFs are cheap

The lion’s share of ETFs are still passively managed and track broad market indices like the S&P 500. The fact there’s no human at the helm and that the goal isn’t to beat the market, just mirror its performance, means costs can be kept to a minimum.

The average cost of a passively managed fund, according to Unbiased, is currently around 0.15%. For active funds, that average jumps to 0.67%.

Not only do these index ETFs tend to charge a fraction of the charges levied on human-led active funds, they’re also nearly always cheaper than their index-tracking open-ended cousins.

All fairly straightforward so far.

The fork in the narrative comes when we bring in the new wave of ‘actively passive’ ETFs. 

These are mostly thematic investment vehicles targeting a specific sector like cloud computing or medical cannabis and can be just as expensive or even more so than the active funds a lot of investors are eschewing.

The ARK ETF range headed up by Cathie Wood is a prime example. MiFID II regulations make the ARK range difficult for investors to access in the UK but US holders of the likes of ARK Innovation (ARKK) were paying 0.75% in 2021 for the privilege.

That’s over twice the cost of ownership of actively managed investment trusts like Scottish Mortgage.

The argument here is normally that by following a proprietary index made up of companies in forward-thinking sectors, and backed by research, these funds are worth the higher fees.

The jury is out on whether that is true or not but the strange thing is it’s not a million miles off the message active fund managers espouse.

The point here is not to discredit either approach but simply to call out that if you naturally attach low fees to ETFs, that view needs to change. Not completely, but enough for you to check.

In the end it’s about getting value for money no matter what you’re paying, whether that’s 0.05% for a UK market-tracking ETF or towards 1% for an active fund aiming to beat the market.

2. ETFs don’t guarantee diversification and reduced risk

The second biggest reason investors are opting for ETFs is the inherent diversification they offer. 

That’s most true for the broad market-mimicking ETFs or multi-asset options but less so for mandates concentrating on a single sector. These funds may hold a wide range of companies but in many cases it’s probable they are all vulnerable to the same sorts of external influences, which actually increases risk.

Again, we’re not tarring all ETFs with the same brush. Increasingly, with the advent of new strategies and aims within the industry, we’ll all have to do the opposite. 

More holdings doesn’t always equate to reduced investment risk and each ETF will have to be judged on its own merits. Throwaway assumptions about the natural diversification to be found in ETFs are now past their sell-by date.

That’s especially important as retail investors are showing an appetite for products like leveraged ETFs. These funds use derivatives to potentially enhance returns, or the inverse returns, of an underlying index. 

Having garnered assets in the region of $50bn to $70bn over the past decade, last year’s trading boom meant investors held nearly $135bn in leveraged ETFs by the end of March in 2021, according to Morningstar data.

The problem here is not necessarily the headline risk of these products (which is substantial) but rather in the way daily compounding affects their returns.

In his book Investing for Growth Terry Smith gives a clear example of how they can perform differently than we might expect.

Source: Investing for Growth, 2020.

In the first example, the index finishes up +3% whereas the 2x leveraged ETF ends the period -15% because of how gains and losses are amplified over time.

These can be highly risky products and share very little DNA with the type of ETF most investors are used to. 

3. ETFs can be a huge help for your personal asset mix

It’s one thing knowing you should hold a range of assets. It’s quite another to actually choose them. And it’s only when investors try to populate their portfolios that they finally ask themselves, “What should my asset allocation actually look like?”

ETFs can be extremely helpful here.

Those with a more conservative risk profile or near-term goals might want a product with a lower allocation to equities and higher weighting to bonds. An investor with a more aggressive risk profile or longer-term goals might want the opposite.

For both of these and every level in between there is an ETF to suit. And whether it forms the core of your portfolio around which you make more active choices, or it makes up the bulk of your holdings, it’s a great way to match your risk profile exactly with your investments.

Of course, it is possible without these styles of ETF but that brings in the responsibility to rebalance those assets to keep them in line with your goals and risk profile.

In this sense, the value of ETFs isn’t in any ability to guarantee stellar returns, their worth is in forming a basis for good long-term investing habits. That can be a real stumbling block for investors starting out, one possibly easily overcome through some of the simplest products out there.

4. Do ETFs pay dividends?

We’ve said before how important racking up dividends over the long-term is. To reiterate, reinvesting income payments over the long-term is absolutely essential to the value of total returns.

But that journey can be stunted simply by choosing the wrong version of an ETF.

If you’ve picked up a ‘distributing’ or ‘INC’ (income) version (you’ll see that information at the end of the fund’s legal name), any income you receive will land in your account as cash. That might suit you if you want to withdraw and use that money. 

If you want it automatically reinvested back into the ETF, go for the ‘ACC’ (accumulation) class so your dividends start to snowball and generate compound interest of their own over time.

The last thing you want is to leave your account to gather dividends over time, only to realise later they’ve just ended up in a cash pile rather than being put to work in the stock market. 

If you want to make doubly sure you’ve got the right one, check the fund’s description on the Freetrade app.

5. Measure tracking error

How do you check if an ETF is performing in line with expectations? Take a look at the tracking error.

This measures how far an ETF has strayed from its benchmark index and, ultimately, how well it’s doing its job.

A certain degree of tracking error is to be expected - after all, the ETF is constantly rebalancing and dealing with cash and the index isn’t.

But the reason most investors opt for an ETF is the aim of replicating an index minus fees. If it’s not doing this consistently it’s not holding up its end of the bargain.

There are a few reasons why performance might deviate slightly. One of the main ones is how ETFs treat dividends. While companies go ‘ex-dividend’ one day (meaning the cut off date to receive the next dividend has passed) and actually pay out some time after, index providers often calculate that dividend reinvestment on the same day the share went ex-dividend.

Making up that difference can be a tricky task and essentially ensures performance will never mirror the index perfectly. But it shouldn’t swing wildly round the benchmark either.

We’ve created one of the UK’s leading stock trading apps to help everyone build their wealth over the long term. Join over 1 million users that have chosen Freetrade for their general investment account, investment ISA or personal pension.

Important Information

This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.

When you invest, your capital is at risk. The value of your portfolio, and any income you receive, can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

Eligibility to invest into an ISA and the value of tax savings depends on personal circumstances and all tax rules may change.

Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).

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