Investors in the UK and all over the world have tinkered and adapted the basic ETF (exchange traded funds) model, producing a number of structures built around the simple idea of index tracking via a fund.

Mutuals or unit trusts

The mass-market variation of the index fund is the mutual or unit trust. an open-ended vehicle thats priced daily and can issue new units on a daily basis if it so chooses as more investors buy in.

Unit trusts are typically run by large fund-management groups such as Fidelity, Scottish Widows, Legal and General, and HSBC in the UK and Vanguard in the US. No discrepancy should exist between the underlying value of the units and the price quoted to your adviser or dealer. Any dividends that come from holding the shares in the portfolio are distributed as a yield, paid on a regular interval, to unit holders.

ETNs

In essence, an ETN (exchange-traded note) is simply a tracker (like an ETF) but where the IOU from the issuer is very explicit.

Many synthetic ETFs feature quite a complex structure of swaps and collateral, which the ETN replaces with a simple IOU. The bank promises to make the payment and your IOU becomes in effect another form of bank debt. If the bank that issues the IOU goes bust, you lose your money.

The advantage of an ETN is that its simple, easy to structure and can be built quickly. These attributes help keep costs to the minimum and allow an issuer to respond very quickly to changing markets. They also help the issuer design a product that tracks a more complex, more opaque market that cant be replicated using a traditional structure. This innovative structure means that ETNs are especially useful in tracking things such as commodities or replicating hedge-fund strategies.

The counterparty risk of investing in an ETN is very high because youre effectively buying into a bond issued by the bank, and an unsecured one to boot! If the bank goes bust you may not get your money back which is precisely what happened to many investors in Lehmans ETNs.

Investing in commodities

Exchange-traded commodities (ETCs) do what they say on the tin track a physical spot commodity market price (one traded with the expectation of actual delivery) or a composite commodity index (a grouping of assets that represent a particular market sector).

In effect, theyre close to the synthetic ETF structure in that the fund managers (ETF Securities in the UK) buy swaps with a counterparty, which in turn guarantees to pay out the returns of the underlying index.

With many commodities-based funds, the underlying index isnt comprised of shares, but lots of individual futures based contracts which track a spot price for the delivery of a commodity at some point in the future.

Thinking about tax for total returns

Dividends present issues for many ETPs. The problem, especially for international index funds, is that different tax jurisdictions treat dividends in different ways. Some countries such as the US impose withholding taxes and apply a charge at source. Other countries have an entirely different framework and tax the investor who receives the dividend payment. This complexity introduces the concept of net and gross dividends.

More fundamentally, those humble dividend payments matter hugely to total returns, regardless of whether theyre taxed at source or not. Many long-term studies of returns over the last 100 years reveal that dividends account for 3090(!) per cent of the total returns from investing in risky shares, which in short confirms the importance of dividends. But what matters even more than the dividends is that you choose to reinvest them in the underlying stock or index.

When you combine the compounding effect of dividend reinvestment with a constantly increasing dividend yield (hopefully the absolute payout increases with inflation), you discover that dividends can be the primary source of total returns over the long term.

Some index trackers dont pay a dividend at all because their underlying asset class, such as commodity futures, isnt one that yields a dividend. Some share markets such as Japan also yield a very low dividend.

But most mainstream share markets and all bond markets pay out an income and effectively you have two options:

Take those regular dividend payments (usually quarterly or half yearly) as a payout and then reinvest directly via a broker or deploy the cash elsewhere.

Find a tracker fund that follows the total return from an index.

A total return index (both the index and the ETF) fund rolls up the regular dividend payments into the index level; that is, it doesnt pay out the yield but reinvests it. This can be especially useful for investors in emerging markets where tax regimes vary enormously and loads of currency and capital control issues exist.

It can also be useful for the forgetful investor in mainstream markets who wants someone else to worry about constantly reinvesting the dividend.

Total return indices tend to be tracked by synthetic index funds, simply because the mechanics of dividend tracking and reinvestment can be time-consuming and expensive.

Best to use an IOU from investment banks where that counterparty promises to pay the total return including dividends; that is, the bank does all the complicated number crunching to include the dividend payment. The bank probably has a huge inhouse tax team who are better able to work their way through complex dividend tax regimes.

When you look at an index, investigate whether the total return is net of dividends and withholding tax (the most common form) or gross (the tax hasnt been deducted).

Value stocks: Fundamental trackers

Fundamental indices arent developed by religious extremists but are indices that pick up on the idea of dividends but broaden their focus to so-called value stocks generally. Clearly some investors dont believe that the market always puts a sensible price on certain unloved stocks.

In particular, value investors believe that an investment strategy that constructs an index entirely around its market capitalisation isnt necessarily the greatest idea, because it rewards stocks whose share price is growing fast and not the company with a sound balance sheet or solid, sustainable profits growth.

Some value investors prefer to invest in an index whose constituents are decided not by the manic mood swings of the market but by their fundamental value, using measures such as the dividend yield (higher yielding stocks are a bigger percentage of the index) or a combination of fundamental factors including the book value of the companies.

An active approach to managing indices

In recent years a strange form of tracker fund has emerged on the scene. These low-cost funds still track an index like any other ETF or ETN, but the index itself is based on the active decisions of a fund manager or economist/strategist. These indices can change in composition quite quickly because the rules governing them can be quite flexible.

Many traditional ETF investors believe that these actively managed indices are a sham and just another way of packaging up active fund managers decisions, inside a cheap index tracking fund. But theyre undoubtedly popular in areas such as bonds and in multi-asset class portfolios.

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