A direct route to tracking as stocks get back to their peaks

Exchange-traded funds can be simple and profitable but make sure you know what you are buying. By Julian Knight

Don't get gored: Exchange-traded funds are easily traded, but they do have pitfalls (AFP/Getty images)

Little seems to be halting the upward surge of global stock markets. All-time highs for the FTSE all-share index are finally within sight as markets have recovered the ground lost during the world financial crisis of 2008. Of course what goes up can just as easily go down – so goes the law of investment gravity – but nevertheless small investors are increasingly looking at the best ways to make the most of this new market bull run.

First there are direct share investments, potentially profitable with the added attraction of dividend payments but highly volatile. Then there are collective investment schemes, such as unit or investment trusts, where investor money is pooled and then used to buy in shares and make other investments by a professional money manager.

And then there are passive funds, which simply look to track a share or other investment index. The most popular of these passive funds are trackers (as in tracking a particular index) but there is another game in town, one which arguably holds greater attractions for investors, exchange-traded funds.

Exchange-traded funds are sold on the stock market just like ordinary shares and in their simplest form they track the moves in a particular index, just like a tracker. However, unlike a tracker fund, ETFs don't come with an annual management fee and can be traded in the click of a mouse, almost instantly.

"ETFs are a highly democratic form of investment," Hector McNeil, chief executive officer of provider Boost ETP, said. "They are completely liquid – can be bought and sold with no difficulty – and all they cost to invest in is the trading fees imposed by the stockbroker."

There are thousands of ETFs, investing in hardy perennial investment areas such as the FTSE, Dow Jones and precious metal markets as well as esoteric areas such as wheat or the Baltic stock exchanges.

Think of an investment and there is likely to be an ETF diligently tracking ups and downs in price. This is exciting to some, bewildering to many, but above all there are pitfalls to watch out for. "There are so many investments to be had that it is important that investors understand what the ETF is investing in and preferably choose a provider with a track record in the sector," Eleanor Hope-bell, head of UK Spdr etfs at State street said.

ETFs aren't just for a rising market scenario, which is in sharp contrast with a passive tracker fund, where your returns can only be had in a rising market. "Should you have a strong conviction that the market is going to fall you can also buy an inverse ETF, which will effectively short the market and that can provide useful portfolio insurance," Peter Botham, chief investment officer at private bank Brown Shipley, said.

There is another more exotic type of ETF, which borrows (leverage, as borrowing is called in investment circles) to make the most of any investment bet made. Leverage has been used by standard fund managers for many years to maximise returns.

Mr McNeil, whose firm Boost offers this type of product, says this allows sophisticated investors for the first time to compete on a level playing field with city fund managers: "You can get up to three times the return for the same amount of capital; the flipside is you can amplify losses. Most investors only benefit when the market rises but with an exchange-traded product, as they are called, we can invest in futures so can hedge their bets, which is the same as fund managers can use. In effect, our product gives you access to the same tools."

Crucially, unlike spread betting, an ETP can only ever go wrong to the extent that the original investment is lost. Nevertheless there are those who are very cautious about their advent: "You have to be careful. There are ETFs that are leveraged and that can mean that if things go wrong it really hurts you. So you have to know what you are doing. Investors also need to be aware that there is still a bid-offer spread with ETFs so if you are buying and selling a fair bit then the costs will mount up, so they're not necessarily as cheap as some people might think," Mr Botham said.

And there is of course the seemingly age-old dispute over what is best, a passive fund or an active one run by a manager. Many studies have shown that the majority of fund managers underperform passive funds but there is always the chance of outperformance from a flesh-and-bones fund manager, which you only get from an ETF if it is in effect structured, like the Boost ETP fund. In other words, it can leverage.

Despite their low cost even basic ETFs haven't entered the mainstream of UK investment portfolios. "In the UK probably only 3 per cent of funds are ETFs, while in the United States the figure is closer to 10 per cent," admits Ms Hope-Bell. But this doesn't mean they can't play a greater role.

Robert Currie, head of private banking UK at Nedbank Private Wealth, sees a place for active and passive investment vehicles in investors' portfolios. "ETFs are ideal for gaining inexpensive exposure to markets in which the majority of active managers struggle to outperform, such as the FTSE 100 stock index. As the number and variety of ETFs has expanded it gives investors more options to diversify their portfolio across different sectors and asset classes," Mr Currie said.

But this diversity raises concerns that investors could be buying investments which they think are cheap trackers but are leveraged or invested in high-risk markets or corporate bonds: "Regulators are forcing providers to label themselves correctly and be more transparent, " says Ms Hope-Bell.

As ever with investments, even ones that at first glance look low cost and relatively simple, the watchwords are caveat emptor.

Passive investment made easy

Take your pick

With passive investment performance depends on the ups and downs in an underlying market rather than the stock-picking prowess of an individual fund manager. Two main types of passive investment are tracker funds and exchange-traded funds.

Tracker funds: Sold by fund managers in the form of individual units, so trading is not instantaneous and can be costly. Generally easy to understand and transparent. Annual management charges are usually imposed by the fund group.

Exchange-traded funds: Traded on the stock exchange like a company share and generally low cost and easy to dip in and out of. Can be complex and some are invested in either very esoteric markets or are higher risk as they borrow to maximise returns.