Chris Morcom, director and private client adviser at Hewison Wealth management. Photo: Erin Jonasson

Alexandra Cain

Although they are both regularly reduced to their acronyms, contracts for difference and exchange traded funds are very different beasts.

One is a highly leveraged product, the other tracks an underlying index and is widely considered to be a low-risk investment.

According to Stephen Small, UBS Global Asset Managements ETF capability manager, ETFs are an efficient and low-risk way of gaining access to the Australian sharemarket.

Australian equity and fixed income ETFs track indices and therefore offer instant diversification across a portfolio of underlying assets. The underlying assets are held in trust by an external custodian on behalf of the end investor. This is a very important characteristic, which ensures there is no counter-party risk to the ETF issuer.

The structure is designed to provide an exposure to the value of the underlying assets, and not the value of the ETF issuer.

He explains that all Australian equity and fixed income ETFs are physically backed, meaning they hold the underlying assets in trust for the benefit of the investor. They do not use derivatives to gain exposure or to leverage the fund.

As Small notes, ETFs are considered to be traditionally low-cost investments. They charge a single annual management fee only. They do not charge ongoing interest fees, such as those incurred with CFDs. With ETFs you can never lose more than your initial investment. This is compared to CFDs that offer recourse loans where you can lose much more than your initial investment.

Another benefit of ETFs is that, as they hold the underlying shares in a unit trust, all dividend and franking credits are passed through to the end investor.

With CFDs, you gain access to the underlying asset synthetically, so generally speaking you do not receive franking credits, says Small.

Risks and returns

Chris Magnus, a financial adviser with financial planning firm Ark Total Wealth, explains a CFD is a contract for the difference in the price of an asset between now and the agreed contract date in the future. You would use a CFD if you want to increase the leverage of a particular trade. This means that by borrowing a large component of the trade it allows you to significantly increase your gains. At the same time, however, it can significantly increase your losses.

Magnus says ETFs are great if you would like to take more of a passive investment view for your investments. By investing in an ETF you will receive the return of that particular index. So if the ASX 200 increases or decreases by 10 per cent then so will an EFT that tracks the ASX 200.

They are also traded on the stockmarket, which means they can be traded like a normal share.

But CFDs are a great way to access a number of different investment opportunities around the world, he adds

Although both are relatively low-cost investments, Christopher Reynolds, operations director at ThinkForex, argues that for active traders, CFDs are even cheaper than ETFs.

They also provide more features and more flexibility, while offering a similarly large universe of trading instruments. The ability to short sell opens up two-way trading and the opportunity to hedge. A massive difference is that an ETF is usually treated as an investment. Like buying shares in a company, you are typically putting up the full value of the purchase and looking to hold for the longer term, he says.

Short-term strategies

In contrast, CFDs are a high-risk derivate product, and are typically traded, not invested. Says Reynolds: CFDs are usually used for short-term strategies. They involve high risk and high reward potential. ETFs, being longer term in nature, will usually be expected to yield smaller gains over a longer period of time. You could potentially use a CFD to hedge exposure in ETFs, but the opposite is virtually impossible.

Comparing CFDs to ETFs is like comparing FX trading to stock investing two completely different instruments used for vastly different strategies, albeit with the same ultimate goal profitability.

Chris Morcom, director and private client adviser at Hewison Private Wealth, says in his business, ETFs are used to gain exposure to certain sectors of the global sharemarket. An example is the iShares Global 100 ETF, which tracks the investment results of an index comprised of 100 large-capitalisation global equities, or the iShares Emerging Markets ETF, which seeks to track the investment results of an index composed of large-and mid-capitalisation emerging markets equities.

In terms of the drawbacks of an ETF, Morcom says the major one is that there is no expert analysis or stock selection being done on the investments included in the fund.

This can mean stocks in the ETF might be those in which an investor would normally prefer not to invest. In addition, when a particular sector is hot, it can push share prices up for that sector. If the index includes companies in that sector, the fund will be forced to buy more shares in those companies, pushing the share price up further. This can result in the underlying index fund buying more of these companies when their share prices have gone up, and when the market reverses selling when the share prices fall.

In his view, the main difference between a CFD and a ETF is that the former is generally used more for speculation, whereas an ETF is generally used for longer-term investment.

CFDs are complex, involve financial leverage, and users of these instruments can stand to lose a lot of money if their position taken in the market is proved wrong. I would never recommend such an investment for a client, as I am not interested in speculating with clients funds, says Morcom.

Nevertheless, both CFDs and ETFs offer compelling propositions for investors. As to whether they are right for you, the idea is to develop a long-term investment plan, as well as an understanding of you own risk appetite, before committing any money to any investment product.

The Australian Financial Review