Know your onions when it comes to ETF’s

28th June 2013

For those readers not in the investment world and not familiar with the acronym ETF’s, it stands for ‘Exchange Traded Funds’, in simple terms they are trackers. In other words they track the performance of an index (such as the FTSE 100) either up or down.

Some argue that ETF’s are better than actively managed funds in terms of longer term performance as most fund managers tend to miss the point at which a market starts to pick up and some will argue that Actively managed funds are better as the fund manager can react when a market is falling by selling some holdings to reduce the risk etc, whereas trackers will do what they say on the tin and track the market all the way down as well as all the way up.

Another bone of contention has always been around the costs/charges when comparing an ETF to an Actively managed fund and up until 1st January this year, I would have found in favour of ETF’s in the majority of cases (if the investment decision was purely based on price). However, since the 1st January this year when the FSA’s Retail Distribution Review (RDR) was introduced and as a result most fund houses have now made available ‘clean’ & ‘super clean’ share classes (lets not expand on this bit of jargon at this point, or we could be here all day as this probably warrants another article all of it’s own) the argument based on cost alone is fairly neutral.

For those who still prefer ETF’s (for whatever reason) it pays to know your onions! as they are not all the same.

Running an ETF from the fund houses point of view can be very complex, for example, the indices themself don’t account for the transaction and management costs associated with running a fund, so an ETF is always going to slightly underperform the index it is tracking due to the charges/fees drag.

The other major complexity is how the ETF is structured, in other words, should it fully replicate the index it is tracking (this could be very expensive unless you have scale. To buy every company in the FTSE 100 for example everytime someone invested into the ETF would mean 100 separate trades).

There are essentially 4 ways ETF’s are usually structured, and before you invest you should be aware of which type you are investing…………….

1. Full Replication

Some managers aim to fully replicate the index, which means holding every stock in the same percentage as it is represented in the index. When the index rebalances, so too will the fund – this ensures the accuracyof portfolio holdings, but it can also limit flexibility.

Full replication is perhaps the purest method of index tracking, and it should produce a low tracking error. However, it can also be very expensive, since the transaction costs tend to be high for illiquid stocks. Fund size is therefore crucial, because larger funds are able to benefit from the economies of scale and minimise the impact of individual transactions to make the methodology viable.

2.Stratified Sampling

Rather than attempt to hold all of the stocks in an index at the exact weightings, some ETF’s hold a representative sample of the market – a strategy known as ‘Stratified Sampling’. Shares are selected by dividing the index into sub-groups (say, by industry sectors for equities, or by maturity bands for bonds), and representative samples are taken from each.

The objective here is to create a portfolio that mirrors the characteristics of each sub-group – and which, collectively, will also represent the whole market and therefore track the market index. This can be achieved using computer based models, but, compared to other methodologies it tends to have greater human interaction in the selection of the representative stocks.


This is often described as the ‘black box’ technique of passive strategies, because computer or statistical models are used to make buying and selling decisions. In this form of sampling, mathematical models, based on historical data, are used to construct a portfolio that aims to track the chosen index.

This approach is not easily adaptable to a changing investment environment and it will always play catch-up with the market. It is, however, the cheapest type of ETF to operate.

4.Synthetic Replication

I know this sounds like some sort of special persil or arial washing powder, but rather than buying the physical securities, the ETF can use derivatives to obtain ‘synthetic’ exposure to an index.

This method is generally more complex and leads to other risks, such as ‘counterparty risk’ i.e. who is actually standing behind the derivative and will they still be there when it’s time to pay out?

This is certainly the riskier method but by using derivatives some ETF’s are able to offer a return of an index x 2 etc as they are leveraging to increase exposure but this can also work in the opposite direction, so please beware and remember the old saying….”if you play with fire, you are likely to get burnt”

In summary – when it comes to the active vs passive argument there is no clear winner between actively managed funds or ETF’s, it just depends on the style of management you prefer and the markets you want exposure to.

However, it pays to know your onions before choosing an ETF to ensure you are comfortable with the underlying investment method being employed.