Investors couldn’t get enough of exchange-traded funds (ETFs) in 2021.
Global ETFs attracted $1.22tn of our money last year according to Refinitiv Lipper. That’s 71% higher than in 2020 and meant the funds waltzed into this year with a record $9.94tn under their arms.
2022 has been no different with BlackRock, one of the largest providers of ETFs, saying it had seen net inflows of $56bn into its iShares ETF range in the first quarter of the year.
Given active fund managers aren’t guaranteed to beat the performance of the index they compare themselves to, like the US S&P 500, a lot of investors are opting for a more passive approach instead.
Most ETFs aim to mimic the performance of an index rather than trying to top it. So investors won’t beat the benchmark but they’re less likely to drastically underperform it. And they won’t be exposed to high fees for the most part. Swings and roundabouts.
We’ve said ‘most’ twice here though because of the growth in popularity of active ETFs. Strategies like Cathie Woods’ ARK range create their own indices and then track that, so it’s a more hands-on approach than ETF investors might be used to. And their fees can be at the same level as the traditional active fund crew.
The ARK funds certainly rode the wave of lockdown tech winners but a big drop-off in performance since then is a classic reminder of why the best performing ETFs for 2021 might not be the best ETFs to buy now.
Before we even think about the best ETFs for 2022 and beyond, it’s worth taking a broader look at what’s out there. It’s a side of the industry that’s developing new products at breakneck speed so there might just be options on the table you’ve never heard of before.
The rise of active ETFs is a good example of the blink-and-you’ll-miss-it pace of new ETF styles hitting the market.
Let’s start off by looking at what ETFs Freetrade investors were buying in 2021.
Before we get stuck in, it’s important to highlight that this is a wrap-up, not a suggestion or recommendation that you buy or sell any of the securities mentioned.
Remember that everyone has their own goals and unique financial circumstances. These, along with your tolerance for investment risk and time horizon, should inform the mix of assets in your portfolio.
Our resource hub for investing in the stock market might be able to help make that blend a bit clearer for you and our guide on how to invest in stocks is a great start for first-time investors. And if you are still unsure of how to value stocks, speak to a qualified financial advisor.
🤔 Read more: What is an ETF and how do ETFs work?
Broad equity index ETFs can give investors a simple route into global stocks markets through a readymade basket of stocks.
A lot of investors use them as the basic building blocks of their portfolios and build around them with individual stock choices. A core and satellite approach like this means you aren’t exposed to one single country or sector in particular, and still get to tilt your portfolio towards individual stock stories.
ETFs tracking the US market were the most popular among Freetrade investors last year. Eagle eyes will spot that they’re London-listed. That’s because most UK investors can’t access US-based ETFs, as the funds don’t tend to meet the necessary UCITS requirements on this side of the pond.
It’s also worth calling out that all the ETFs here don’t necessarily offer instant diversification in the way we often expect. The iShares Global Clean Energy ETF might give you access to a range of companies in the sector but it won’t diversify away the risk of a sector-specific hit to performance.
Source: Freetrade, April 2022.
In the high school canteen of assets, bonds have been the shy, geeky kids next to the equity quarterbacks ever since the financial crisis.
Record low interest rates (even with the current upward trajectory) have taken the shine off fixed income products. And the case for bonds doesn’t look a lot brighter if inflation keeps rising.
Assets with a fixed income can’t react to surges in inflation and are doomed to underperform it in real terms if inflation stays above the return they can provide.
More broadly though, investors might be using bonds for diversification over a period of volatility in equity markets. It’s not always about that upside potential and when the downside rears its ugly head, holding assets that don’t tend to fall as much as shares can be a useful breakwater.
Specifically on bond ETFs, investors get the advantage of liquidity (buying and selling a bond ETF can be faster and easier than trading an actual bond) with a fairly steady duration too.
Duration describes how sensitive different types of bonds are to interest rate movements. The best bond ETFs often hold a range of bonds to maintain that duration on investors’ behalf, making the job that bit easier for the end holder.
Source: Freetrade, April 2022.
When you see commodities, think raw materials.
Metals, energy resources and agricultural goods like wheat are the building blocks of the global economy.
And when there are fewer of the ones we rely on, or it’s just harder to get them, their prices can rise. When there’s too much for us to use, prices can go the other way. Supply and demand, and all that.
But commodity producers are able to raise their prices at source. If you’re the one getting something out of the ground and deciding the price, you can cover your own costs easier. This can help hedge against inflation.
It’s not always a sure thing though. There’s a ceiling to what you can charge and keep your customer coming back. And what you’re producing is probably not unique, raw materials can be found the world over after all.
Both sides of the coin mean the likes of gold are regularly touted as solutions to inflation but the long-term evidence is less convincing. During recent high periods of inflation, gold has had a negative return. And research from Duke University found that gold only maintains its purchasing power when it’s held for over a century. Talk about a long-term investment horizon.
Regardless, as they often perform differently to equities and bonds, commodities can be useful for diversification. And commodity ETFs can be a one-stop shop vehicle for exposure to a basket of different commodities or to track the price of something specific like oil or silver.
Some ETFs physically hold whatever they’re tracking, others use a range of derivatives contracts for their exposure so they don’t have to hold the actual asset.
If you want to know how a specific commodity ETF tracks its index, make sure to look at the fund factsheet.
Source: Freetrade, April 2022.
🤔 Read more: How to invest in commodities
Property can be a bit of a hassle as an investment. Buying a house or commercial site is costly, suffers from wear and tear and if you need some money for a sudden expense you can’t just sell a small part to cover it.
That’s why a lot of investors choose to access the asset class through a fund. Most often they go for real estate investment trusts (REITs) which have their own share price behind which lies a basket of commercial buildings and warehouses.
It’s a much more liquid way to access the sector and REITs have to pay a large portion of their earnings out as income so there’s an added benefit there too.
One step further away from the actual bricks and mortar are real estate ETFs like the iShares MSCI Target UK Real Estate UCITS ETF (UKRE). ETFs like these track a range of REITs and property companies to give investors wide exposure to assets in the sector.
It’s tempting to think of this as wider diversification and, to a certain extent, it is. But if REITs as a whole are suddenly hit by an external factor like tax or policy changes, they’ll all be affected. It’s another reason why simply holding more of something isn’t a watertight diversification strategy. Though it should offer you access to more of the main players in a certain sector or market.
At one end of the ETF spectrum you’ve got your simple index trackers, following large indices like the S&P 500. At the other end things get a bit spicier, and should be treated with caution.
Here we have ETFs that don’t represent physical baskets of stocks. Instead, they try to give investors access to themes, derivatives and short-term plays carrying a heightened level of risk.
Often, these ETFs aim to capitalise on any sudden fears sweeping a market. So a volatility ETF tends to move in the opposite direction to the market, because when investors get scared they often sell, sending stocks down and increasing the level of fear.
The Chicago Board Options Exchange Volatility Index (VIX index) is commonly known as the main fear gauge, and it’s what these short-term traders normally want access to.
Notice we’re talking about a lot of things sensible long-term investing stays clear of, namely speculation, movement prediction and huge levels of short-termism.
There may be times when institutional investors seek out volatility ETFs as a hedge against things going south in the short term. But, even then they only really aim to hold them for a few days to manage the risk of loss. With such a short time frame, a lot can go awry, and an investment hardly has any time to smooth out any fluctuations.
We all want the most from our investments and it can be tempting to want to amplify whatever gains we achieve.
This train of thought can lead us towards products that make use of leverage, essentially carrying the possibility of boosting returns to two or three times what the actual asset achieves on a given day. But a massive caveat here is that leveraged ETFs can also boost losses to the same extent, so they’re certainly not a surefire way to consistently top up returns.
Leveraged ETFs use derivatives to potentially enhance returns, or the inverse returns, of an underlying index.
There is a problem here though. It’s 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.
Anyone going anywhere near them needs to understand the greater risk that comes with seeking greater returns, as well as how the example above can make them a much less appealing long-term hold.
Inverse ETFs give investors exposure to the inverse returns of an underlying index. That means, whatever the actual index does, the ETF will do the exact opposite.
If we take the Xtrackers S&P 500 Inverse Daily Swap UCITS ETF (XSPS) for example (phew, that’s a mouthful), when the S&P 500 goes up the inverse ETF should decrease in value. When the S&P 500 falls, the inverse ETF should rise.
Investors can use inverse ETFs to help protect against falls in their portfolio.
For example, if you have a lot of S&P 500 stocks in your portfolio, you might buy shares in an inverse S&P 500 ETF.
It can seem odd to hold both at the same time (aren’t they counteracting each other?) but often the hedging strategy is only a short-term move, if there is a potentially market-moving geopolitical event on the horizon you’re worried about.
If you tip the balance and put a bigger weighting on the inverse ETF it might be because you genuinely think the index will fall and you want to try to profit from falling prices.
One big difference to call out between the two strategies (normal ETFs and their inverse cousins) is how they actually gain access to the underlying companies.
While an ETF tracking the S&P 500 usually owns shares in the companies that make up that index, an inverse ETF uses derivative contracts (swaps or futures) to generate the opposite performance.
Derivative strategies can be more complicated than regular long-only investing and can carry more risk, so most providers recommend investors have a more advanced understanding of financial markets before using them. It’s important to understand these risks and have a clear idea of your objectives for buying the product.
Counterparty risk means that the person or institution on the other side of a derivative transaction may be unwilling or unable to meet its obligations, like giving back shares they have borrowed. This could lead to a substantial decline in the value of the contract, negatively impacting the performance of the fund. Fund regulations typically include limits on the proportion of a fund that can be exposed to a single counterparty in a transaction in order to mitigate this risk.
Another thing to remember is that, as we’ve said, these products are designed to be held for a very short period of time, sometimes just a day. If you hold the asset for longer than a day, you must keep in mind that the performance of the fund may not continue to be exactly opposite to the performance of the underlying index.
To put that another way, investors need to time the purchase and sale of an inverse ETF well in order to generate a positive return. There’s a significant risk of losses accumulating if you put too large a portion of your portfolio into an inverse ETF and time your entry and exit poorly.
If the past few years have shown dividend investors anything, it’s the need to diversify those income streams.
Preparing for the worst, UK and US firms up and down the indices chopped their dividends down over the pandemic to bolster cash reserves. That left those of us relying on that regular dividend income with a huge problem.
And that problem was amplified in sectors like financials. In the UK, the regulator told the nation’s banks to halt dividends altogether and shore up the balance sheet instead.
Those income payments are well on their way to normality now but the whole episode was a lesson in making sure your income isn’t wholly dependent on one company, sector or asset class.
It was also a reminder that consistency of income and the quality of the firm providing it are more important than just grabbing the biggest dividend yields on the market.
So, it’s maybe no surprise to see a lot of these factors represented in the top dividend ETFs investors were buying over 2021.
Yes, there’s a search for high yield but there’s also attention to consistency, low volatility, global diversification and high quality.
Source: Freetrade, April 2022.
Tech is about more than the FAANGs. The big names on the Nasdaq might still get the headlines but the sector’s fall from grace at the start of 2022 prompted a lot of investors to look beyond the pandemic’s chosen few.
Of course, that doesn’t mean the sector is dead in the water, rather its winners might be harder to identify once Covid is a thing of the past.
The good news is investors don’t necessarily need to hitch their carts to just a few tech stocks. Tech ETFs offer exposure to general (and niche) parts of the sector and investors are increasingly looking towards specific themes that might take time to play out rather than the ones shooting the lights out now.
ETFs focusing on robotics, the blockchain, esports and cyber security were among Freetrade users’ favourite ETFs over 2021 and all give access to a theme through a basket of companies rather than just one. That can be useful in emerging sectors, where the winners and losers are still unclear and are constantly jostling for dominance.
Source: Freetrade, April 2022.
But remember, just because the ETF is diversified in the companies it holds doesn’t mean you’re protected if the theme turns out to be a fad.
Last year, the Dutch courts were clear on their message to Shell around the oil giant’s transition away from fossil fuels; get a move on.
Investors buying into the future of energy don’t necessarily need to contend with legacy firms dragging their heels though. More and more investors are choosing to leapfrog the traditional players dabbling in ESG side ventures by exploring new and emerging companies in the clean and renewable energy sectors instead.
And one way they’re choosing to gain exposure to the theme is through clean energy ETFs. The advantage to these funds lies in not having to single out and back one horse in particular. Sector ETFs like these allow investors to follow a theme in general instead.
Source: Freetrade, April 2022.
The biotechnology sector had a huge run from around 2010 until 2015. Pharma companies at the more experimental end of the spectrum captured investors’ lust for high growth and world-changing medical technologies.
But the reality is a lot of healthcare-focused firms have product pipelines that stretch for years. Even if an idea seems promising there’s no guarantee the treatment will pass trials. If it doesn’t, it’s back to the drawing board for the product, and all the investor anticipation fades with it.
A lack of star performers might be why shares in the sector broadly moved sideways from 2015 to 2020. Then came Covid.
Healthcare firms were thrust back into the spotlight and while it’s not necessarily the medtech firms garnering all the attention this time round, the wider theme of healthcare innovation is back in vogue.
But investors might feel that taking a punt on one single company that may or may not provide post-trial value is a risk too far. If so, healthcare ETFs like iShares Healthcare Innovation UCITS ETF (DRDR) could be an attractive way to take part in the theme.
Through a sector-wide ETF, there’s reduced stock-specific risk. That’s an important aspect, given how many trials go south. And, whereas huge pharma firms can have multiple drugs going through trials, smaller firms may only have a few. This can put incredible pressure on a specific product to make it onto pharmacy shelves and operating theatres.
Spreading that risk across multiple firms in an ETF means investors aren’t exposed to just one firm and just one trial.
Source: Freetrade, April 2022.
According to Refinitiv data, global ESG ETFs saw inflows totalling $119.4bn last year, compared with $79.3bn in 2020.
That’s a massive jump, and represents the growing appetite for sustainability in our portfolios. But it doesn’t mean all of these dollars were aching to find a particular environmental angle or were happy to give up gains in return for a moral compass.
Investors are steadily realising that a sustainable business model promotes sustainability overall, including in the returns they’re aiming for. Firms with high ESG standards are much less likely to get fined by governing bodies, get taxed out of existence or face increased regulation.
For a lot of investors, characteristics like taking care of staff, having solid governance standards in place and being sensitive to the community in which a firm operates heighten their investment’s sustainability. And where a model is less likely to face bumps in the road, so too might revenues, profits and overall business success.
That train of thought is likely to be behind some of the inflows into ESG ETFs, as investors want to know the firms they invest in have been screened for sustainability traits, so that they don’t have to do it themselves.
We have to be cautious though. ESG has a woolly definition and it’s starting to be commandeered by investors who know how valuable the label has become.
For example, some of the top tobacco firms wouldn’t meet high ESG standards. But if we consider them as the top producers of vapes, which might help wean people off nicotine, do they suddenly tick the ESG box?
It might seem silly but it’s one way investors in those very non-ESG firms have been trying to stem the rush from some of the biggest ESG losers.
Source: Freetrade, April 2022.
It’s always tempting to look at which ETFs have been the best performers over the past 10 years and think it’s a surefire way to spot tomorrow’s winners too.
Sadly, that’s not how it works.
As you’ve read in countless disclaimers, past performance is no indicator of future returns. That’s because stories play out, companies come and go, and the big themes of yesteryear often fade into the standard themes of today. That makes it especially hard to predict tomorrow.
Have a think back to just before the dot.com crash. Investing in the leading ETFs of 1999 under the assumption the status quo would remain would have hurt.
Looking at the past decade, ETFs tracking big tech, semiconductors, healthcare, medical tech and biotechnology are likely to have rewarded long-term holders with healthy returns.
There’s simply no guarantee that will be the bunch at the top of the next decade’s best performers though.
The good thing is investors can reduce stock-specific risk not just by opting for an ETF but by supplementing thematic strategies with broader index trackers. ETFs tracking the S&P 500 were also among the best ETFs to hold over the past decade.
Again, that’s not guaranteed to be true of the next decade. What it does show us is that it’s possible to take part in many themes, and the wider market, through ETFs as opposed to pinning your hopes on just one stock.
There’s often a misconception in investing that investors somehow ‘graduate’ from ETFs at the start, to single stocks later on. Once you get a feel for investing and market movements, so says this theory, you should be ready to tackle individual companies.
That transition just doesn’t need to happen though.
There’s no rule book that says you have to take that route. While it may be a good way into investing in individual stocks, a massive amount of investors stick with a few simple, broad market index ETFs for their entire investment journey.
If you don’t have the time or inclination to analyse stocks, there’s nothing wrong with steadily drip feeding your money into an index ETF. If you earmark part of your monthly salary for investing and add it to your account regularly, you’ll naturally catch different prices each month, which will smooth out the overall average price you pay over the long term.
When it comes to thematic ETFs which track firms in specific sectors like battery technology or water treatment, just keep in mind that while you’re diversified over many stocks, you’re still exposed to anything hitting the overall sector.
It’s an important thing to remember as over the long term, there are likely to be factors that affect all industries, good and bad.
As we’ve said, a lot of investors actually find a middle ground between solely ETFs and solely stocks. Having a broad index ETF, or group of them, at the core of your portfolio can provide diversification and allow you to make some smaller ventures into individual companies on the periphery of those central holdings.
This is where balance comes into play. It isn’t a strict science, it’s about building your portfolio to suit your needs. ETFs can help make that easier by doing some of that heavy lifting for you. Regardless of your experience (or strength), who doesn’t like an extra hand?