What are the different types of ETFs?
Exchange traded funds (ETFs) are a specific type of fund that, as their name indicates, can be traded like individual shares on a stock exchange such as the London Stock Exchange (LSE).
The first ETF, tracking the FTSE 100 index, was issued in the UK in 2000. While that product still exists there are now hundreds of others tracking returns from a range of different asset classes including bonds, shares and commodities.
There are a number of different things to think about when buying an ETF and the different benchmarks, different structures, different classes and different approaches behind them can all influence how you invest.
Below are the main points you’ll need to consider.
Different benchmarks
For mainstream ETFs covering the major stock market indices, heavy competition means that the costs, performance and level of risk are unlikely to vary too widely, but it is important to make sure the ETF you invest in is tracking the right benchmark for your goals. There can be significant differences - for example MSCI Emerging Markets includes South Korea - which accounts for 10 per cent of the index - but the FTSE Emerging Markets index doesn't.
Different structures
ETFs can be structured in different ways. Physical, or cash-based, ETFs are those whose providers actually purchase and hold the assets or shares of the index they track.
Synthetic, or swap-based, ETFs, by contrast, hold no underlying assets, but are financed by a counterparty, usually an investment bank. While a synthetic ETF can be more accurate than the physical ETF in tracking an index, you are exposed to the risk of the counterparty hitting financial difficulty.
Income or growth?
Like mutual funds, ETFs typically have both distributing and accumulating units. If it is a distributing fund, it will pay out any dividend income to investors on a periodic basis, perhaps quarterly or annually. In contrast, an accumulating fund will automatically reinvest any income received back into the fund rather than paying it out to the investor.
Smart Beta products
A relatively new development, smart beta ETFs are essentially hybrids between traditional index-tracking ETFs and actively managed mutual funds. A smart beta ETF follows a specialist benchmark which seeks to either outperform an index like the FTSE 100 or offer less risk or volatility. The methodology behind the benchmark or index is active but the fund passively tracks it.
What else?
Exchange-traded funds (ETFs) are just one type of exchange-traded product (ETP), a generic term which covers three types of instrument.
- Exchange-traded fund (ETF)
Under European rules, an ETF must hold at least five different securities or assets. They can be used to track the performance of a stock market index or bond index for example. It is not possible to buy an ETF that tracks the gold or oil price, as this would mean the instrument owns just one asset. - Exchange-traded notes (ETN)
ETCs trade on an exchange, just like an ETF, but they can be used to track just one underlying asset. An ETN is actually a debt instrument and it uses indirect replication to generate performance. - Exchange-traded commodity (ETC)
As its name suggests an exchange-traded commodity (ETC) is a type of ETN designed to provide a means of accessing the underlying price trend provided by a single commodity, such as lean hogs, wheat, corn or cotton.