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What is an exchange-traded fund (ETF)?

ETFs have become the vehicle of choice for many investors because of their low costs, simplicity and exposure to different markets. So much so, investors ploughed $516 billion into ETFs over the whole of 2018 and they attracted $3.3 trillion over the past decade

An ETF trades very much like a regular stock on a stock exchange, such as the London Stock Exchange. Like stocks, ETFs experience price changes throughout the trading day as they are bought and sold. Also, all ETFs that consist of dividend-paying stocks will ‘pay out’ the full dividend that comes with the stocks held within the funds.

Where an ETF differs is in its composition. Each ETF is made up of a wide range of stocks and other investments that track anything from stock indices to stock market sectors, commodities, currencies and bonds.

As an example, a FTSE100 ETF is designed to closely track the FTSE100 stock market index – made up of the 100 largest UK firms listed on the London Stock Exchange. Like all index-tracking ETFs, its price movement will aim to mirror that of the index it follows.

Why do we use ETFs?

Our goal is to build the best possible portfolio for you using the most effective underlying securities. That is why we use ETFs.

ETFs are more than just a low-cost strategy. They offer broad exposure to different types of assets, countries and industry sectors, enabling instant diversification. ‘Don’t put all your eggs in one basket’ is sound advice and a well-diversified portfolio of ETFs will reduce your investment risk without necessarily sacrificing returns.

The ETFs we invest in are simple buy-and-hold investments, which passively track the performance of an index or pool of investments. Index-tracking ETFs do not attempt to beat the market like an active fund; rather, they try to be the market.

ETFs have very low fees because tracking an index is inherently less expensive than active management. They are also tax efficient and not subject to 0.50% stamp duty, which is charged on most UK share purchases.

What types of ETFs do you invest in?

Using our pre-defined selection criteria and best execution principles, we regularly survey the landscape of over 2,000 global ETFs and invest in ETFs that are broad-based and have a long-term outlook.

Of course, we are passive buy-and-hold investors and look to ETFs that accurately track their relevant markets; rather than relying on active management. We invest in a range of ETFs across various asset classes, including equities, fixed income, foreign currency, commodities and alternatives.

From time to time, we may switch an ETF in your investment mix for a superior ETF – ensuring continued optimum performance at the lowest cost.

How do we select our ETFs?

Having chosen the asset class, region or market segment we want exposure to, we will then select the most liquid ETFs in each category.

This means ETFs with high trading volumes, low bid/offer spreads and minimal tracking error. We also pick ETFs with low total expense ratios and only invest in ‘physical’ ETFs, which either replicate the index they are tracking in full or sample a proportion of it. We avoid ‘synthetic’ swap-based ETFs entirely, which are more complex instruments that use derivatives - and not the actual assets - to track an index, and can expose investors to additional risks.

And to ensure we remain at the forefront of investment trends, our whole selection process is under continual review.  

What are the risks of ETFs?

The goal of an ETF is to track a specific market index. Sometimes, though, tracking error can occur when an ETF does not perfectly mimic the returns of its reference index. This can result in big price differences; both positive and negative for the investor. Some small level of tracking error is normal in all ETFs, however, and should be expected.

ETFs on overseas markets can also be exposed to currency risk. Although ETFs can give investors access to these hard-to-reach markets, this means some ETFs can be priced in different currencies. Again, currency risk can have upsides as well as downsides – depending on movements in the foreign exchange market.

Fortunately, in the unlikely event an ETF provider did go bust, its assets by law will have been ring-fenced and held by a separate custodian – meaning no money, apart from agreed charges, can be misappropriated out of the ETF.

Do you recommend the same ETFs to everyone?

The simple answer is yes.

Our methodology is based on Modern Portfolio Theory, the award-winning and proven investment strategy. It states that asset class diversification is crucial to maximising your returns for the amount of risk that you are comfortable accepting.

So when we pick an ETF, we want it to best represent a particular asset class; rather than, say, to include a specific stock.

We choose a variety of ETFs to typify each asset class; achieving an optimal blend across equities, fixed income, foreign currency, commodities and alternatives.

Where things differ is in asset allocation. Personal situation dictates what portfolio you will receive from InvestEngine and this will be determined by your investor profile, time horizons and risk tolerance.

So, a risk tolerant investor will receive a different percentage mix of asset classes in his or her InvestEngine portfolio compared to a cautious investor; although it will be the same ETFs used for each but in varying quantities.

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