Exchange Traded Funds

First of all, Exchange Traded Funds are nothing to be scared of! They may sound like some exotic derivative that only rocket scientists can understand but, in truth, they couldn’t be simpler. ETFs are just shares that reflect an index! That’s right, you can by a single share in an ETF and it will follow the combined performance of all the shares that make up that index.

For our purposes, we will focus on an ETF that reflects the FTSE 100. We will also consider its opposite – an ETF that reflects the inverse of the FTSE 100 index. ETFs have codes in the same way as a company’s shares will have a code. Barclays, for example is BARC. This code is used when buying or selling shares through your broker.

There are competing suppliers of ETFs – the two biggest operating in the UK are currently iShares and Deutsche Bank (called db Xtrackers). For my strategy I use:

XUKX – db FTSE 100 Long (for when the index is trending up)

XUKS – db FTSE 100 Short (for when the index is trending down)

So, by buying XUKX I can track the performance of the FTSE 100 index and by buying XUKS I can short the entire index. I told you it was simple!

If you live in Australia, or the USA, you will probably want to base your Index Trend Trading strategy around your national index – the one you are most familiar with. A little bit of research will result in the ETF pair needed to go long and short your chosen index.

The next few paragraphs will give you a little more information about ETFs.

What is an ETF?

Exchange-traded funds (ETFs) are a type of financial instrument whose many advantages over other investment funds (or direct investment in shares) have caught the eye of many an investor. These advantages mean that ETFs are becoming increasingly popular and mainstream, and the range of available ETFs is growing.

Think of an exchange-traded fund as a mutual fund that trades like a stock. By owning an ETF, you get the spread of shares of an index fund plus the flexibility of a stock. An ETF represents a basket of stocks that reflects an index such as the FTSE 100. An ETF, however, trades just like any other share on a stock exchange, with its price changing throughout the day (unlike a mutual fund that has its Net Asset Value (NAV) calculated at the end of each trading day). Buying and selling an ETF through your broker is just like any other share – same commission, similar spread between bid and offer prices. However, in the UK a big advantage is that there is no Stamp Duty to pay.

Advantages

Cost

ETFs are less expensive than mutual funds as they operate at a much lower Total Expense Ratio (TER), typically 0.5% – 0.75% because most ETFs are not actively managed and because ETFs are insulated from the costs incurred by unit trusts of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. Mutual funds can charge 1% to 3%, or more; Over the long term, these cost differences can compound into a noticeable difference. The cost difference is more evident when compared with mutual funds that charge a front-end or back-end load as ETFs do not have loads at all. Because ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Using an online broker this is normally around £10 ($15)

Tax

Internally, within the fund, ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions. In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account (ISA) or a Self Invested Personal Pension (SIPP).

Diversification

Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index. Some index ETFs, known as leveraged ETFs or inverse ETFs use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index.

Flexibility

ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded at the end of the trading day. They can be traded using stop orders and limit orders, which allow the use of automatic stop-losses. Investors can invest as much or as little money as they wish (there is no minimum investment requirement).

Inverse exchange-traded funds

Inverse exchange traded funds are ETFs that, through the use of derivatives replicate the inverse of whatever index or benchmark it is designed to track. By providing performance opposite to their benchmark, inverse ETFs give a result similar to short selling the stocks in the index. An inverse FTSE 100, for example, seeks a daily percentage movement opposite that of the FTSE 100. Because their value rises in a declining market environment, they are popular investments in bear markets, to hedge a portfolio or for use in a trend following system. If an investor were to directly go short on particular stocks he would be exposed to unlimited losses, whether or not the sale involves a stock or ETF. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. Another advantage of inverse ETFs is
that they may be held in ISA and SIPP accounts while short sales are not permitted in these accounts.

Disadvantages

Sometimes ETFs do not successfully track the underlying index and may end a year as much as 1% below the index, but this is not a problem that I have experienced yet.