The transparency and liquidity of exchange-traded funds make them popular with investors, but there are still a few things you should know before you sink your money into them, writes Paul Amery, editor of www.IndexUniverse.eu .

The financial crisis was a nightmare for most asset classes, with money pulled out of investments left, right and centre. But not for exchange-traded funds (ETFs). Money actually flowed into the sector more rapidly between 2007 and 2009 than ever before. From modest beginnings in the mid- 1990s, global ETFs now hold nearly $1trn in assets.

Why are ETFs – which passively track an underlying asset class, be that a stock market index or the price of gold or wheat – so popular? Some of their key characteristics, such as transparency and liquidity, have become even more attractive amid rising concerns over counter-party risk (as investors in structured products backed by Lehman Brothers, for example, have learned to their cost) and widespread lock-ups of investor funds in hedge funds or commercial property funds, for example.

But the main reason is cost. ETFs are just plain cheap. The average annual fee in Europe for a stock-market ETF is 0.37%, says Barclays Global Investors. That compares to 0.87% for an index (tracker) fund and 1.75% for an actively managed fund (whereby a fund manager picks and chooses stocks in the hope of beating the market). Bond ETFs are even cheaper, often costing only 0.10%-0.15% a year. In other words, the average City fund manager has nearly 1.5% a year in performance to make up before breaking even with an ETF. Thats without factoring in trading costs (bid-offer spreads and broker charges), which can easily add another% percent or two.

That 2%-3% a year may not sound much, but long-term it matters, says John Bogle, pioneer of index investing in the US. Assume an average investment gain of 8% a year over 30 years. If this is cut to 5% via fund expenses of 3% a year, then you lose more than half your money over the 30-year term (you end up with £4.32 for each pound initially invested, compared to £10.06 before costs).

But ETFs are not without their detractors. Some unpleasant surprises, particularly from funds tracking more esoteric indices or asset classes, have caused sceptics to wonder if these funds arent just the latest addition to the bankers long list of marketing gimmicks. Is this true? And what risks do investors need to be aware of?

Know your tracker types

There are several different types of index tracker – ETFs, ETCs (exchange-traded commodities/currencies) and ETNs (exchange-traded notes). Almost all European ETFs comply with the EUs UCITS III directive. Without getting too technical, this is a set of Europe-wide rules that set minimum standards for things such as a funds diversification, the way its priced, and which underlying financial instruments (such as derivatives) it can use.

European ETFs fall into two broad categories. First, you have funds which replicate their underlying indices by simply buying the underlying index securities, or a representative sample of them. So a FTSE 100 tracker would hold the stocks making up the FTSE 100 index, for example. This method is used by most of the iShares funds, as well as ETFs from HSBC, German issuer ETFlab and some of the French issuer EasyETFs range. This is usually known as physical, in-kind, or in specie.

Swap-based ETFs, on the other hand (which include funds issued by Lyxor, db x-trackers, Source, ETF Exchange and the majority of European issuers) – replicate their indices by buying a performance swap from a bank, and holding a basket of collateral. The bank guarantees the index return (before the banks fees) via the swap. The collateral is there to provide backing for investors funds in case the bank fails to deliver. Under UCITS rules, at least 90% of the funds value must be backed like this at all times.

Since Lehman Brothers went bust last September, investors have certainly looked more closely at the security of swap-based ETFs. But its worth remembering that, in theory, a maximum 10% loss should result, even if a counter-party fails. And in practice, many swap-based ETF issuers have reduced their uncollateralised exposure to less than 10%, and in some cases 0%. And as swap-based ETF issuers point out, ETFs that physically replicate their indices are not free of counter-party risk either; they often lend out the index securities in return for extra revenue (although these transactions are also backed by collateral).

Its certainly worth being aware of which replication technique an ETF issuer uses, what their collateral policy is, the identity of any counter-party, and to what extent securities are lent out. This information should be readily accessible on the issuers website. But we wouldnt favour one breed of ETF over another.

What about ETCs and ETNs?

ETCs – exchange-traded commodities and currencies – are debt securities, not funds. They offer exposure to the price of one or more commodities or to individual currency rates. Most ETCs have collateral backing, meaning that if the issuer defaults, investors should be protected.

Initially, only a few ETCs tracking precious metals were collateralised and last September, the market in many of these commodity trackers was paralysed for a short time following the blow-up at AIG – a key counter-party at the time. Investor protection has improved since then, but you should make sure that you know the counter-party status before you invest, which should be on issuers websites and in the ETC prospectus.

Were less comfortable with ETNs (exchange-traded notes). These are popular in the US market for tax reasons, but incur full counter-party exposure to their issuer. In other words, if the issuer disappears, so will your cash. While bank risk, as measured by the cost of default insurance, is much lower now than a year ago (if only because of the various Government-funded safety nets), it would be foolish to assume that concerns over bank failure couldnt surface again. So where possible, wed avoid ETNs. The good news is that the vast majority of asset classes can be accessed via ETFs or ETCs, so theres rarely any need for a UK-based investor to go down the ETN route.

What does it really do?

Counter-party risk is something to be aware of, but it shouldnt put you off ETFs. A more common problem is that the more exotic the asset class or investment style, the harder an ETF becomes to understand. And that means they may not always perform as you might expect.

For example, how can it be possible that both the US-listed Direxion Daily Financial Bull and Bear ETFs (which offer three times and minus three times the return on the Russell 1000 Financials index respectively) have managed to lose money for investors in 2009 so far? The Russell index is up 15%; three times that is 45%. Yet the bull fund has lost 34%, while the bear fund is down 94%.

And why have the European-listed ETCs which track the oil price risen by between 5% and 33% in the year to the end of October, when the underlying spot oil price was up 73% (NYMEX West Texas Intermediate front month contract) or 83% (ICE Brent Oil Future) over the same period?

The answer lies in the way the tracker products indices are constructed. Theres a huge difference between a plain vanilla ETF tracking a broad, capitalisation-weighted stock index (where constituents weights are determined by the companies market sizes) and more esoteric indices involving leverage, or indices that are based on futures or forward contracts.

Leveraged ETFs – those which offer plus or minus two or three times an indexs performance – are rebalanced daily. This ensures a constant leverage ratio. But in practical terms, it also guarantees that over time, performance will differ from what an unwary investor might expect. Inverse (or short) ETFs, which provide a daily return of minus one times the underlying index, are also prone to drift over time.

Heres why. Imagine that an index rises over a day by 10%, from 100 to 110. A two-times leveraged daily long index will rise by 20%, from 100 to 120. Fine. But on day two, the market falls by 5%. The underlying index declines from 110 to 104.5. But the doubleleveraged index will fall by 10%, taking it from 120 to 108. As you can see, after two days the leveraged index (+8%) is up by less than double the underlying index (+4.5%).

Repeat this over many daily periods and the drift will grow. All other things being equal, the greater the leverage factor and the more volatile the underlying index, the more drift youll get. And, as you can see, this index drift begins as soon as you hold them overnight. So highly leveraged ETFs are suitable for very short-term traders only.

You could consider holding simple inverse ETFs (those offering minus one times an indexs return on a daily basis) over longer periods, but bear in mind that even these will be subject to drift over time, so you must monitor their performance.

How contango can catch you out

ETFs and ETCs which follow indices based on futures markets (this includes most commodities, currencies, and credit trackers) face tracking problems of a different type. Futures have to be rolled on a regular basis (usually monthly or quarterly) from the expiring contract into a longer-dated one. In many commodities markets, the further out in time you go along the futures curve, the higher-priced the relevant contract will be.

This upward-sloping futures curve is known as a contango. Any passive strategy of rolling from one contract to the next will incur a cost, as the longer-dated contract is more expensive than the shorter-dated one. Thats exactly whats been happening in the oil market this year, and its the reason why oil trackers have not copied the performance of spot crude.

Its not always like this – if futures prices are below spot (a price structure known as backwardation) – youll earn money when rolling contracts rather than losing it. However, contango is the norm for a non-perishable commodity which incurs storage costs (because people expect to be paid more in the future for a commodity which costs them money to hold on to).

There is one exception: gold and other precious metals. These typically have little in the way of a forward curve, meaning trackers can follow the spot price quite closely. Most gold ETCs are backed by holdings of the metal itself, rather than futures contracts, and directly track the spot price after a deduction for fees.

So what should you buy?

As regular readers will know, MoneyWeek prefers plain vanilla investments by and large. The more complex ETFs become, the further they move from their core remit, which is to offer investors simple, cheap exposure to the market of their choice. So unless youre a trader, wed avoid leveraged products.

As for ETFs tracking commodity prices, they have their place (particularly precious-metals trackers), but longer-term investors interested in playing soft or industrial commodities are probably best off finding stocks with exposure to rising prices, rather than betting directly on specific commodities. But that still leaves plenty of uses for ETFs, not least in playing more exotic stock markets. Below, we pick out some of the ETFs we favour to play markets we like.

• Paul Amery is editor of www.indexuniverse .eu , the leading source of news and analysis on the fast-growing European exchange-traded fund market.

Some potential golden opportunities

Most of MoneyWeeks favourite asset classes can be followed using ETFs.

Starting with gold, wed suggest investors hold some physical bullion. But a convenient way to get exposure is via the London-listed ETF Securities Gold Bullion Securities (LSE: GBS ).The ETF is backed with physical gold stored in London, so it tracks the spot price.The management fee is 0.4% a year. As for gold miners, our precious metals writer Dominic Frisby favours the US-listed MarketVectors Gold Miners ETF (NYSE: GDX ) that tracks the HUI, which is the index of US-listed unhedged gold stocks (those gold producers who have full exposure to the gold price).

Among developed markets, we still favour Japan, which Andrew Smithers of Smithers & Co believes may be the only significant market in the world which is not seriously overvalued. One of the least expensive London-listed ETFs is Lyxors Topix ETF (LSE: LTPX ), which simply tracks the Topix index. It has an annual management fee of 0.5%. Those more interested in getting specific exposure to Japanese small caps – which are even cheaper than the broader market and more exposed to the domestic consumer – the iShares Japan Smallcap ETF (LSE: ISJP ), with an annual fee of 0.59%, gives you exposure to more than 400 small-cap Japanese stocks.

Emerging markets (EM) in general are looking more expensive these days, but investors should have exposure to these regions for the long run. There are too many individual country ETFs to list in detail here, but if youre looking for a general EM fund, Cris Heaton, who writes the free MoneyWeek Asia email. suggests buying an ETF that tracks the MSCI Emerging Markets index, which has Brazil, South Korea, China, Taiwan and South Africa as its five biggest holdings; the biggest issue (a common problem with EM funds in general) is that its biased towards sectors such as financials and energy, with relatively little direct exposure to consumer themes. There are London-listed ETFs tracking the index from iShares (LSE: IEEM ), db x-trackers (LSE: XMEM ) and Lyxor (LSE: LEME ). Fees are in the 0.65%-0.75% range, so the choice is down to how often you want dividends paid or whether you want them reinvested. iShares also offers an MSCI Emerging Market Smallcap ETF (LSE: SEMS ). The geographical focus is similar, but theres a heavier weighting in consumer stocks.

On regional funds, Asia has the best choice. The broadest large-cap funds are the db x-trackers MSCI AC Asia Ex Japan (LSE: XAXJ ) and MSCI EM Asia (LSE: XMAS ). The second is more of a pure EM fund; it doesnt have Hong Kong or Singapore (but does include South Korea and Taiwan, which, confusingly, are developed countries whose stock markets are still classed as emerging). Latin American trackers such as the iShares MSCI Latin America (LSE: LTAM ) are dominated by Brazil, with a lesser weighting in Mexico.

What about value stocks?

There are fundamental ETFs that track stocks based on metrics such as dividends and book value, rather than their market capitalisation. This is meant to cure the main problem with trackers, which is that they end up investing more and more in sectors and companies as they become increasingly overvalued (such as during the tech boom). With fundamental ETFs you get to track the best companies without overweighting the latest fad in the stock market. Sounds great – but while we like the idea, fundamental ETFs have yet to take off in a big way. Invesco closed down 19 fundamentally weighted ETFs in May.

And while an ETF that tracks the FTSEs top dividend payers sounds a good idea, the trouble with mechanically tracking such stocks is that a high yield often signals a dividend is about to be cut. For now, this is one area where wed buy an investment trust – such as Neil Woodfords Edinburgh Investment Trust (LSE: EDIN ). Or, as the number of secure dividend-paying blue-chip FTSE stocks is relatively low, just buy the shares yourself.

• This article was originally published in MoneyWeek magazine issue number 463 on 27 November 2009, and was available exclusively to magazine subscribers. To read more articles like this, ensure you dont miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now

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