Here we seek to address some frequently asked questions about ETFs and other exchange traded investments.
If you're unable to find what you're looking for, please do not hesitate to phone us on 0117 900 9000 or email us.
What are Exchange Traded Products (ETPs)?
Exchange Traded Product (ETP) is the collective term used to describe Exchange Traded Funds, Exchange Traded Commodities, Exchange Traded Currencies and Exchange Traded Notes.
What are Exchange Traded Funds (ETFs)?
An Exchange Traded Fund (ETF) is a basket of investments that usually includes shares and bonds. Funds are a ready-made investment portfolio run by a professional fund manager. They provide access to a diversified portfolio for usually a much lower cost than purchasing the individual investments yourself.
ETFs can be bought and sold on a stock exchange, just like shares. Most track an index – a collection of securities that represent a certain sector or region. For example, the FTSE 100 is an index that represents the largest 100 companies in the UK.
When you buy an ETF, you are buying a slice of the ETF’s underlying portfolio.
What are Exchange Traded Commodities/Currencies (ETCs)?
ETCs are another form of exchange traded product that offer a way to track the performance of a commodity, commodity index or currency. This includes markets like oil, precious metals, natural gas, and livestock.
There are two main ways ETCs track a commodity or currency:
- Physical ETCs – these buy and store the commodity in vaults or warehouses. This is common in precious metals like gold or silver.
- Synthetic ETCs – in some cases buying and storing a commodity is difficult or impractical. For example, wheat and similar commodities which perish over time. Or, with a currency ETC, holding large sums of money in a different currency with a bank. Instead, a synthetic ETC will agree to purchase or sell a certain amount of a commodity or currency at a fixed price or rate at a time in the future. If the exchange rate or commodity price changes, the value of the contract will too. This is known as a futures derivative.
As the end of one contract approaches, the ETC will then start another and keep going. Synthetic ETCs are higher-risk investments. Many are only designed for investors to hold for a short period of time. Over longer periods the performance of a synthetic ETC will not always match that of the commodity or currency it tracks. As such, they’re only suitable for people with a high level of knowledge and experience, and who are able to accept the extra risks.
What are Exchange Traded Notes (ETNs)?
Exchange Traded Notes (ETNs) are a type of debt security, often issued by financial institutions like investment banks. The financial institution will issue ETNs to investors, who in return will pay a fee for using the investment. The ETN then aims to track the performance of a specific index like the FTSE 100.
Let’s take an example. If the FTSE 100 returned 5% in one year, and an ETN was designed to track the FTSE 100, then at the end of that year, the investor should in theory also receive a 5% return.
However, where ETNs differ to ETFs is that they don’t necessarily provide the investor with ownership of the securities from the index. Instead, the financial institution gets the flexibility to provide the return to match the index however they see fit. As a result, using the example above, the investor may receive a 5% return, without having ever owned the underlying securities from the index they wanted to track.
One of the biggest risks of using ETNs is that if the issuer of the ETN were to go bankrupt, the investor could lose all of their invested capital.
ETNs are complex investments and should only be traded by knowledgeable investors.
How do ETFs differ from Index Mutual Funds?
Index mutual funds and ETFs are both passive investments that offer investors exposure to markets around the world by tracking an underlying index, like the FTSE 100. However, there are differences between the two.
Mutual funds value and trade only once a day, usually at midday, so investors won’t know exactly what price they’re buying or selling at until after the trade’s taken place.
ETFs on the other hand are traded on a stock exchange, like shares. They also track an underlying index, but the prices of ETFs fluctuate through the trading day. The ability to trade ETFs throughout the day adds greater flexibility, however timing the market is a tricky, if not impossible, exercise.
Mutual funds are also typically single priced, meaning the buy and sell price is the same. Whereas ETFs have different buy and sell prices, known as the ask and bid respectively. The difference between the buy and sell price is called the bid/ask spread. A small bid/ask spread means investors should achieve a market price close to the value of the underlying investments. These spreads are managed by market makers, a designated broker-dealer firm that tracks an ETF’s value throughout the day.
Both mutual funds and ETFs have annual management charges that are paid to the company offering the investment. Their passive nature means they usually have lower annual management charges compared to active funds that aim to beat an index.
Transaction costs for index funds are zero on the HL platform, but this is not the case for ETFs. As they are treated and traded like shares, both a buy and sell instruction for an ETF is subject to the HL share dealing charges. The difference in dealing charges can be a key consideration when deciding if a mutual fund or ETF is right for a portfolio.
There is no charge from HL to hold ETPs within the HL Fund and Share Account. The annual charge to hold ETPs in the HL ISA or SIPP is 0.45% (capped at £45 in the ISA and £200 in the SIPP).
What’s the difference between physical and synthetic ETPs?
Physically replicated ETPs buy the physical holdings of the constituents within an index. This could be either shares, bonds or commodities depending on the index that the fund tracks. Full physically replicating products provide investors with the lowest counterparty risk as they’re unlikely to use derivatives.
Counterparty risk is the probability that the other party in a transaction may not fulfil its part of the deal and may default on their obligations. This can be more significant for synthetic ETPs as discussed below.
A synthetic ETP (also called a swap-based ETP) invests money in derivatives and swaps rather than in physical securities. A synthetic ETP aims to replicate the performance of an index without necessarily owning the assets.
Instead, the ETP will buy a swap (a type of derivative) usually from an investment bank which agrees to match the return of the index. The investment bank will sometimes hold collateral – securities like shares, bonds or cash to compensate the ETP if the swap provider ran into financial difficulties and could no longer provide the swap. If that happened, the collateral basket would be returned to the ETP to account for any loss.
Synthetic ETPs may be used when it is difficult or costly to hold the underlying assets within the fund. For example, holding agricultural products would be difficult in practice. Instead swaps used to replicate the index remove this barrier for investors.
How do ETPs replicate an index?
There are three main ways an Exchange Traded Product (ETP) replicates an index. Other strategies may be used, so investors should ensure they have read the prospectus and other relevant documentation prior to investing.
Fully replicated ETPs - These ETPs hold every investment, in proportion, within the index they are aiming to track. For example, a fully replicated S&P 500 ETF would hold all 500 companies in the index and in the same proportions. Investors should in theory receive the same return as the index, less the investment manager’s fees. In some indices, fully replicated products need to buy and balance lots of smaller holdings, which can increase costs.
Partially replicated ETPs - These ETPs do not hold every investment in the index. Instead the manager chooses a portfolio designed to perform in line with the index, without including every stock or bond. This process is often called ‘optimisation’ or ‘partial replication’ for shares and ‘sampling’ for bonds.
Partial replication is common when there are a large number of holdings in the index. This is because it can be costly to buy and sell the smallest investments that don’t make as much difference to performance. There are different ways to partially replicate an index. Some investment managers exclude investments that fall below a certain threshold, whereas others look to find a substitute basket of stocks that represent performance.
Synthetic ETPs - These ETPs do not hold the investments within the index they aim to track. Instead the ETP will buy a swap (a type of derivative), usually from an investment bank which agrees to match the return of the index.
Synthetic ETPs can be useful for tracking the underlying asset without incurring the costs that the ETP issuer would otherwise have had to pay for storing the product. For example, a physically backed ETP that tracks gold will have to pay costs associated with its safekeeping. Because synthetic ETPs use derivatives to track the price instead, they don’t have these additional costs. However, the biggest risk for synthetics is the reliance on the investment bank and the ETP could run into issues if that third party defaulted.
How do commodity ETCs work?
There are two types of commodity ETC.
- Physical ETCs buy and store the commodity they want to track, often in bank vaults or warehouses. This is most common in precious metals like gold or silver. However, in some cases holding the underlying physical commodities would be extremely difficult. Wheat, for example, would spoil if held for any length of time, and the cost of storing millions of barrels of oil would be prohibitive and incur large storage costs which would have to be passed onto the investor. In these instances, some ETCs use a ‘Synthetic’ structure instead.
- Synthetic ETCs, rather than using the physical commodities and tracking the price directly, use the futures market to gain exposure to movements in the price. The futures market is where participants buy and sell commodity and futures contracts to track the price of the underlying commodity.
However, the use of futures is not confined to commodities which are difficult to store. Each ETC's prospectus offers more details on how futures may be used to replicate performance. You can access most prospectuses on the 'at a glance tab' of the ETP you're interested in on our website. Futures-based commodity ETCs are complex investments.
How do currency ETCs work?
Most currency ETCs follow a currency index by using a type of derivative called a futures contract, which tracks an exchange rate. The ETC enters into an agreement to exchange a certain amount of currency at a fixed rate at a time in the future. If the exchange rate increases or decreases in the interim between the rate now and the fixed rate in the future, then the value of the derivative does too. This will subsequently impact the performance the investor receives either positively or negatively.
Futures-based currency ETCs are complex investments, and most are generally only suitable for knowledgeable investors.
What are derivatives?
Derivatives are a type of financial contract whose value is dependent on an underlying asset or benchmark. They’re essentially a contract between two parties and the price of the contract comes from any changes in the underlying asset value.
These contracts can be used to trade any number of assets and come with their own risks. Derivatives are commonly used in ETPs to access different markets and can also be used to hedge against certain risks.
For example, a gold futures contract is a type of derivative whose value is based on the market price of gold and therefore aims to track the price of the physical commodity. The benefit of using derivatives over physical commodities can be the cost of ease and use. Agricultural products, for example, would often spoil if held for any length of time, and storing millions of barrels of oil would be difficult, incurring large storage costs which would have to be passed onto the investor.
Derivatives are also used by portfolio managers to reduce the cost of trading in the underlying investments like shares. Trading in shares can incur dealing charges and taxes, whereas derivatives aren’t subject to those costs. This can make it easier for an ETP to replicate index performance at a lower cost and help keep a tighter tracking difference over time.
How are ETF units created/redeemed?
ETFs and mutual funds are made up of units which are owned by investors. However, the way these units are created for each fund type is different.
When you invest in a mutual fund, the cash is given directly to the fund manager to buy the investments that make up the fund. In return you receive a certain number of units in the fund which represent a proportion of the total assets.
However when you invest in an ETF, you buy it through the secondary market – a market where investors buy and sell securities. This means units in the ETF are sold between investors rather than directly via the fund manager. Unlike shares, ETF units don’t get onto the exchange via an initial public offering. Instead, ETFs rely on a creation/redemption mechanism.
ETF units available on the secondary market are already in existence, and the investor is taking them from someone else. Units are not created or redeemed on the secondary market. Instead, they are created by a group known as Authorised Participants (APs). APs are often large broker/dealers, that are authorized by the ETF issuer to participate in the creation/redemption process.
An AP creates an ETF unit by first buying stocks to represent the index it’s looking to track. It then passes those stocks to the ETF issuer. The ETF issuer then provides the AP with an ETF unit in exchange for those stocks, which the AP then takes away and can sell to the market and to investors.
When redeeming an ETF, the unit is passed back to the AP. They can then swap the ETF unit with the original ETF issuer for the original stocks that they offered them.
What is currency hedging?
Currency hedging is a process used to reduce the risk of the potential changes in an exchange rate of one currency in relation to another. Companies or investors with assets or operations across national borders are exposed to these currency risks. This leaves them open to potential losses as the currencies they are exposed to across various countries fluctuates.
To reduce that risk, currency hedged ETPs use derivatives to try and minimise the effect of those exchange rate fluctuations. Using hedging can protect or harm the performance of an ETP depending on the direction of those currency movements.
Currency hedging normally comes with an additional cost to the ETP.
What does 'leveraged' mean?
Leveraged ETFs are designed to multiply the short-term performance of a particular stock market, index or commodity – such as the FTSE 100 index or the price of gold.
Let’s take a FTSE 100 2x daily leveraged ETF as an example. It aims to replicate two times the daily percentage change in the FTSE 100 index. If the index goes up by 5%, the ETF will go up by 10%. Likewise, if the index went down by 5%, the ETF would go down by 10%.
Leveraged ETFs are intended to be held for a short period of time, often less than 24 hours. Leverage is very much a double-edged sword. On one hand, the value of your investments can climb rapidly if the market moves in your favour. On the other hand, any gains and your original investment can be cleaned out should things take a turn for the worse. Over the longer term, leveraged returns can vary significantly from the index.
“Inverse ETPs” are another type of ETP that are used to provide a positive return when the price of the market or asset they track falls. For example, if the FTSE 100 index fell 5% in one day, a FTSE 100 2x Daily Short ETF should provide a 10% positive return.
Leveraged ETPs are complex investments, and most are generally only suitable for knowledgeable investors.
What is securities lending?
Some ETFs lend the investments they hold in the fund to a third party in exchange for a fee, which can help offset some of the fund's management charges, reducing the cost to the investor. All physical ETFs are permitted to lend stock, though not all currently do. Synthetic ETFs, which use derivatives to track a benchmark, and ETCs generally do not lend stock.
At all times the fund remains the beneficial owner of the investments it lends and is entitled to all dividends. It also has the right to recall the investments that have been lent to the third party at any stage. The ETF is normally given collateral (often cash or a different stock) to hold whilst the security is on loan. This collateral would be used to cover any losses in the event that the third party can’t return the investments on loan.
Some fund groups also provide protection for investors using indemnities to reduce the risk of any loss if borrowers can’t return the investments on loan.
Will I always get my money back?
Like all stock market investments, the value of an ETP will rise or fall and neither the amount invested, nor any income is guaranteed. All ETPs are linked to the value of an asset or index, but in times of market uncertainty or setbacks any money invested in an ETP could be lost. For example, an ETP that tracks the S&P 500 index would fall around 10% if the index fell 10%.
In extreme events, ETPs can be suspended from trading, which means investors can’t buy or sell an investment and may lose their money.
What are counterparties, is there a risk?
Counterparties are third parties, often investment banks, who are involved with some aspect of running the ETP. For example, a counterparty might be an institution providing a "swap" derivative to help the ETP track an index, borrowing a stock as part of a securities lending programme or the financial institution issuing an ETN.
If a counterparty ran into financial difficulties, there is a chance that the ETP and subsequently the investor could lose money. This could involve larger costs to the ETP, the ETP could cease trading temporarily or, in the worst-case scenario, be wound up altogether.
Investors can assess counterparty risk by considering the followings:
- Is there an indemnity provided with counterparties to protect investors from any potential loss?
- Do counterparties accept or provide collateral like shares or bonds to cover any potential losses?
- How many counterparties are used?
- Which counterparties are used?
- For securities lending, are there limits to the amounts the ETP issuer will lend from each fund?
- Has the ETP issuer ever suffered losses from the securities lending program? If so, why?
This information can usually be found on the ETP provider’s website or by contacting them directly.
What is collateral and what is its purpose?
Collateral is a set of stocks, bonds or cash, which may be related to the index the ETP tracks. It’s sometimes used when an ETP has dealings with a counterparty. For example, ETFs hold collateral when they lend stock from their fund to a third party. This collateral would be equal to the value of the stock lent. This protects the ETF in case the third party can’t return those stocks on loan.
Synthetic ETFs normally hold collateral of at least 90% of the value of the ETF. Most synthetic ETFs rebalance their collateral regularly, often either daily, weekly or when the collateral drops below a certain level to ensure it stays within the set limit, like 90% in the example above.
Many managers keep collateral in synthetic ETFs over 100% of the value of the ETF, in some cases this may be as high as 110%. Products that rebalance their collateral holdings tend to be less risky as they’re constantly checking they have the right protection in case of an issue with a counterparty in the future.
Are synthetic ETPs riskier than physically backed ETPs?
ETPs are exposed to different risks and synthetic ETPs are not necessarily riskier than physical products. Synthetic ETPs are often perceived as riskier investments because they use swaps produced by an investment bank to replicate the benchmark. This counterparty risk adds some complexity in terms of understanding how these investments work.
While physical ETPs invest in physical assets or securities, they can also lend stock to a third party. This means both types of product are exposed to counterparty risk if the third party gets into financial problems.
The swaps used by Synthetic ETPs may also have costs which the ETP issuer does not disclose. This does not necessarily increase the risk of the way the fund works, but it does increase the risk to investors who don’t receive the expected returns.
In all cases, we suggest that it is always a mistake to invest in something you do not understand.
What is UCITS?
UCITS (Undertakings for Collective Investment in Transferable Securities) is a set of voluntary rules which many ETFs follow. ETFs which are UCITS compliant must follow minimum standards - that includes holding a diversified portfolio, publishing clear guidance on their charges and taking steps to safeguard investors' money.
Some ETPs are not eligible for UCITS standards - including ETCs, ETNs and US-listed products. UCITS products are not necessarily safer, nor are non-UCITS products necessarily riskier, but if a product is not UCITS compliant you should take extra care in reading the relevant issuers' documents.
Am I covered by the Financial Services Compensation Scheme (FSCS)?
Many ETPs are domiciled outside the UK and therefore not covered by the UK's FSCS. However, you may be covered by a compensation scheme in the region where the ETP is based. You will need to check rules individually to verify this is the case. An ETP’s domicile can be found in the Key Investor Information Document (KIID) and Simplified Prospectus.
Are thematic exposures risky?
A thematic ETP offers the ability to invest based on a particular theme such as electric vehicles or climate change. Thematic investing helps investors find companies that are part of megatrends with the potential for long-term growth.
They typically use custom-made benchmarks, which invest in companies related to the theme. A group of experts usually select suitable companies. This additional research can result in higher fees compared to a fund tracking a major index like the FTSE 100.
The performance of specialist or thematic areas of the market tends to come in waves – when a particular area is in favour it normally benefits all funds investing there, but the reverse is true too and some trends can be short lived. This means investors should be prepared to take a long-term view and accept the associated volatility.
Some companies focused on ‘the next big thing’ can be small, emerging companies. These companies can have good growth potential, but they’re also higher risk than investing in larger more established companies.
Investors should read the Key Investor Information Document (KIID) and Simplified Prospectus carefully before any investment. In some cases, a complex or thematic ETP may not perform as expected. It’s important to consider exactly what’s included in an ETP rather than just relying on the name of the investment.
Trading at a Premium/Discount
At the end of every trading day, every ETF publishes its NAV (Net Asset Value). That NAV is supposed to be a fair and accurate assessment of what one share of that ETF is worth, based on the value of the investments in the fund.
Because ETFs trade on an exchange, they also have a current market price which can be independent of the NAV. The market price can be influenced by other factors than what the underlying investments are worth, such as investor sentiment.
If the price of the ETF is trading above its NAV, the ETF is said to be trading at a “premium.” This might be because investor sentiment is stronger than usual, pushing up the price. Conversely, if the price of the ETF is trading below its NAV, the ETF is said to be trading at a “discount.”
In relatively calm markets, ETF prices and NAV are generally close. However, when financial markets become more volatile, ETFs quickly reflect changes in market sentiment, while the NAV may take longer to adjust, resulting in premiums and discounts.
When ETFs trade at a premium, investors pay more for the ETF than what the basket of investments is worth (the NAV). Whereas when trading at a discount, they pay less for that same basket.
How do I find out the specific risks associated with my ETP?
For full details relating to the risks of a particular ETP you should read the relevant Key Investor Information Document (KIID) and Simplified Prospectus. These can be found on 'at a glance' tab of the ETP factsheet on our website.
If you are still unsure or need further assistance, please contact our Investment Helpdesk on 0117 900 9000.
What is an index?
An index represents the performance of a set of investments. For example, the FTSE 100 is an index containing the largest 100 companies listed on the UK stock market. Most major markets have indices that can be used to track their performance, for example in the US, the S&P 500 tracks the performance of 500 large US-listed companies. They can be used to track a range of investments like shares, bonds, property, precious metals, agricultural products, and currencies.
Normally these indices are run by a company that defines which investments are included and what proportion of the index each represents based on a set of predetermined rules. Often the biggest, most widely traded companies make up the biggest holdings in the index, though this is not always the case.
Some indices weight each company equally instead or use factors like dividend yield, company earnings or volatility to determine how much of the index they should make up.
What are Smart Beta ETFs?
Most indices follow the price of shares or bonds and are constructed so that the biggest, most widely traded securities are the largest holdings in the index. However, some indices are created to consider alternative behaviours or metrics. Smart Beta ETFs are investments that track these alternative indices and are commonly perceived as a blend between active and passive investing.
Smart Beta ETFs can focus on factors like dividend yield, company earnings or the volatility in the investment price. It’s important to understand how the index that the ETF is tracking is constructed and its ongoing selection process for securities, as there are a large variety of products in the market. Investors can usually find this information in the ETP’s Key Investor Information Document or on the Factsheet.
Do ETFs pay a dividend?
ETFs are normally set up as either income (also known as distributing) or accumulation. Income ETFs pay out dividends to holders as cash. Accumulation ETFs do not pay a dividend. Instead, the income is reinvested back into the ETF, with the aim to grow its value over time.
Our factsheets provide the latest information regarding an ETF’s dividends. Simply locate the ETF and view the 'dividends' section on the ‘at a glance’ tab. Please remember dividend payments can vary and are not guaranteed.
How do I search for ETPs?
We have created a search tool to allow investors to locate the ETPs of their choice. You can search by ETP provider, sector or name.
How often can I buy or sell ETPs - is there a minimum holding period?
There is no minimum holding period when investing in ETPs. You can buy and sell at any time within normal market hours. Please note there are costs associated with buying and selling ETPs - you pay stockbroking commission every time you deal and there is a difference between the buy and sell price - called the spread.
Can I buy all ETPs through Hargreaves Lansdown?
The majority of ETPs that trade on the London Stock Exchange, as well as European and American ETPs, can be bought and sold through HL. The full range of ETPs available can be found using our search tool. If an ETP is not available on our website, please call our Dealing desk on 0117 980 9800 and we can check availability.
Many ETPs are complex and perhaps risky, therefore EU regulations restrict who can invest in them. You will need to successfully complete a questionnaire before investing in complex ETPs.
Can I hold ETPs in my ISA, Fund and Share Account or SIPP?
Most UK ETPs can be bought and held within an HL ISA, HL LISA, HL Fund and Share Account or HL SIPP. To see if a particular ETP can be bought or held within an ISA, Fund and Share Account or SIPP, please view the ETP factsheet.
What is the bid/ask spread?
At any given time, there are two prices for any ETP: the price at which someone is willing to buy that stock (the “bid”) and the price at which someone is willing to sell (the “ask”). The difference between these two prices is called the “bid/ask spread.”
The reason spreads exist is because, in any open market, investors try to negotiate the best prices they can get. If you’re looking to buy, you’ll naturally want to see if someone is willing to sell for less than the last traded price. Conversely, if you’re selling, you’ll naturally hope that someone will be willing to buy it for more than the last quoted price. Spreads are simply the result of buyers and sellers negotiating on prices. The wider the spread, the more it will cost you to trade.
Bid/ask spreads are important to ETP trading because they trade like single stocks, so they have bid/ask spreads.
Spreads widen and narrow for various reasons. If the ETF is popular and trades with high volume, then bid/ask spreads tend to be narrower. But if the ETF is unpopular, or if the underlying securities of the fund are highly illiquid, meaning they can’t be easily traded, then that can lead to wider spreads.
Overall, the narrower the bid/ask spread, the lower the cost to trade.
What is the indicative spread?
The indicative spread is an estimate of the spread shown on each ETP's factsheet, based on the most recent buy and sell prices available.
What factors affect the spread?
One of the most important factors affecting these spreads is the investment or index that an ETP follows - spreads tend to be higher if these are smaller or less frequently traded securities, or those that can be more difficult to buy and sell, like emerging markets. Larger, more frequently traded ETPs may have lower spreads but they tend to increase when markets are more volatile.
The ETP will also make small administration charges to the Authorised Participant (AP) for creating and redeeming shares. The more APs there are quoting for an ETP, the more competition in the market, driving down the costs and subsequently the spread. Lower spreads should reduce the overall cost for investors.
The way the ETF replicates the index also affects the trading charges incurred. Physically backed products need to invest in all (or an optimised basket) of the securities in the relevant index, and in doing so can incur dealing costs like stamp duty on UK equities. These factors can push up costs increasing the spread for buying or selling.
The spread varies over time and is not predictable – they’re often highest shortly after the stock market opens and just before it closes.
What does it cost to buy and sell ETFs and ETCs through Hargreaves Lansdown?
You can buy and sell ETFs and ETCs online from £11.95 per deal. There is no stamp duty to pay on purchases of ETPs.
What does it cost to hold ETFs and ETCs with Hargreaves Lansdown?
There are no charges from HL to hold ETFs and ETCs within the HL Fund and Share Account. The annual charge to hold ETPs in the HL ISA or SIPP is 0.45% (capped at £45 in the ISA and £200 in the SIPP).
What is the annual charge on an ETP?
Most ETPs quote an ongoing charge figure, which is the sum of charges deducted from the product, as an annual percentage. The ongoing charge figure is made up of the fund manager’s fees for running the portfolio, along with other costs, like administration and marketing. However, synthetic ETPs and currency hedged ETPs may have additional costs that are not included in this figure like charges payable to the investment bank. For full details you should read the issuer's important documents. You can find the TER and the important documents on the 'at a glance' tab of the ETP factsheet on our website.
Other charges, such as dealing costs for buying and selling the underlying investments, will also be charged to the ETP and will increase the cost of ownership. If the ETP tracked the market perfectly, and there are charges involved, then the performance of an ETP will fall behind the index by the cost of those fees.
What is the annual charge on an ETC or ETN?
Most ETCs and ETNs also quote an ongoing annual charge figure. It is important that you read the issuer's important documents. You can find cost figures and the important documents on the 'at a glance' tab of the ETP factsheet on our website.
What does Reporting Status mean?
Reporting status refers to the tax reporting regime for funds. Most ETPs are domiciled outside the UK - as such they are often treated as offshore investments for UK taxpayers.
ETP investors pay income tax on any dividends received. If an ETP is domiciled outside of the UK and the investor realises any gain on that fund it could be taxed as income instead of capital gains. This could subject the investor to significantly higher levels of taxation. This may not be the case if an offshore ETP has UK reporting status for the entire period that the investor holds it. Tax is complex and depends on your circumstances - for more information consult a tax accountant.
Investors can find this information on the ETP’s factsheet or Key Investor Information Document (KIID).
Will an ETP perform identically to the index it is tracking?
It's not possible to invest directly in an index and whilst ETPs try to perform as closely in line as possible to an index, this is often not perfect.
The most common measure of an ETP's ability to track its index closely is called tracking error. Tracking error is the difference between performance of the ETP and its corresponding benchmark. A more precise ETP is said to have a lower tracking error.
While a lower error is preferable, not all tracking error is easy to predict or explain. For example, the index that an ETP tracks does not incur the costs of buying, selling, and owning securities. Whereas a fund will incur these charges – these costs detract from performance, which can therefore be slightly different to the index.
Tracking error can also be influenced by changes made to an index. Sometimes securities may be added or removed from an index, or the proportion of a security may increase or decrease. An ETP that tracks that index may also need to make the same changes. These don’t necessarily happen instantaneously, and the lag and costs of trading can contribute to tracking error.
Tracking difference versus tracking error
Tracking difference and tracking error are key measures that help evaluate the performance of passive funds.
Tracking difference is the difference between a passive fund's performance and its benchmark over a certain period. It tells you the extent to which a fund has performed worse or better than its benchmark. For example, if a benchmark returned 10% over a year and the fund returned 9.98%, the tracking difference for that period would be -0.02%. Tracking difference is usually negative for passive funds due to the costs involved that detract from performance.
Tracking error gives us the consistency of a passive fund's tracking difference over the same period of time. It measures the extent to which a passive fund's return differs from its benchmark. It's the annualised standard deviation of the tracking difference data points for the given time period.
Can tracker funds ever outperform?
While uncommon, tracker funds might outperform their benchmarks on occasion There are generally three reason for this:
- Tracking difference can occasionally be positive over shorter timeframes. This may be due to a fund pricing mismatch, which should be corrected over time and shouldn’t be a sign of sustained outperformance.
- The fund is earning extra revenue from additional activities – e.g., securities lending. That said, lending revenues rarely fully offset charges.
- The fund is tracking its index inaccurately. Possibly the fund is partially replicated and has struck lucky due to some small differences between the way the fund and the index is invested. However, imprecision can work both ways and there is also the potential for these funds to underperform more than should be expected, so investors should bear this in mind.
Factoring in dividends and withholding tax
The performance of most indices is calculated without factoring in the dividends that are paid by the underlying companies or the implications of withholding tax. Withholding tax is a tax levied by an overseas government on dividends or income received by non-residents. For example, the US Government charges non-US residents withholding tax of 30% on any income received from US investments.
The index may not factor in these taxes, but ETPs will. This extra cost can contribute to the difference in performance between the ETP and the index.
Some indices contain shares that can be difficult to buy and sell. These are typically smaller companies' shares or companies listed in emerging markets. However, it can affect any company where the amount of shares traded daily is low. The investment manager responsible for running the ETP may choose to not to invest in some of these companies and instead focus on larger companies within the same index that can be acquired more easily.
Partially replicating an index doesn’t necessarily mean the ETP can’t track its index closely. However, there is a chance it could create a difference in performance, for example, if the smaller companies in the index go significantly up and down in value but aren’t held in the ETP.
When dividends or other cash payments are received by the ETP the investment manager may hold them as cash. The cash may receive a small daily interest payment, but this is likely to differ from the return if that money had been invested.
Sometimes the ETP will use this cash to buy futures contracts to represent the performance of an index. For example, an investment manager might prefer to hold a FTSE 100 future until they accumulate enough money in their cash pot to buy all the holdings in that index.
Doing this helps reduce the impact of holding a large amount of cash in the fund and is a cost-effective way to manage an ETP. Often investment managers will have limits within their funds on the amount of derivatives (i.e. futures contracts) that can make up the fund.
ETPs and rolling futures positions
One reason why some ETP performance is misunderstood is a function of how the futures that sit within the fund work. Some ETPs have futures within them that ‘roll’ over from one into another. The process of ‘rolling’ refers to moving into a new futures position as the old one expires.
A future is a derivative contract that allows someone to buy a fixed amount of a specific commodity at a set date in the future.
The price of a future aims to represent the spot price of the underlying security. The spot price is the current price in the marketplace at which a given security, commodity or currency can be bought or sold for immediate delivery. While futures are used as a proxy for this spot price, the price of a future and the underlying security do not always move in line with each other.
The futures price can differ from the spot price for a number of reasons, including interest rates, the cost of storing a commodity, and market expectations. For example, if oil has a spot price of $100 per barrel and it costs $2 per month to store and insure a barrel of oil, the futures price for delivery of a barrel of oil in a month's time may be $102.
The situation where the futures price is higher than the spot price is known as 'contango', and the opposite is known as 'backwardation'.
Contango in particular causes problems for ETPs which use futures contracts. Most futures contracts expire on a rolling monthly basis and, as it costs significantly more to store and insure a barrel of oil for a month than for a day, these costs fall as the end of the contract approaches and the price of the future moves towards the spot price.
In the example above, assuming the current, or 'spot', price remains at $100 per barrel, an ETC purchases a futures contract for one barrel of oil which expires in a month's time for $102. After a month, the ETC will need to 'roll-over' the futures contract - effectively selling the old future and buying a new one for a month's time. If the old future was not sold, the ETC would have to take delivery of the physical oil (which it has no need for). The futures contract purchased for $102 has reduced in price to $100 as it nears expiry. The cost of a new contract is $102, so the ETC has made a loss of $2 even though the spot price has remained constant.
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