Exchange traded funds (ETFs)

Exchange traded fund (ETFs) and exchange traded products (ETPs) have become a popular option for many investors. Their flexibility, liquidity and low costs have made them seem an attractive proposition. According to data from independent research firm ETFGI, in 2015 the global ETP sector reported record inflows of $372.0 billion, a 10 percent increase on the previous record high recorded in 2014.

Unlike a traditional mutual fund, an ETF trades on a stock exchange in much the same way as an equity does. It can hold a variety of assets, such as bonds, commodities or shares.  An investor does not have any ownership of these underlying assets, but instead is paid a proportion of profits, such as earned interest of dividends.

ETFs tend to track an index, which is why they are often labelled as passive investments. This is as opposed to active investments, where a manager aims to beat the market by making investment calls.

ETFGI states a number of reasons why an investor might use an ETF. These are:

• equitise cash
• implement diversified exposure to a market
• comprise a core or satellite investment
• be a long term strategic investment
• implement tactical adjustments to portfolios
• use as a building block to create entire portfolios
• allow investors to hedge the market
• use as an alternative to futures and other derivative products

However, some have drawn attention to potential risks that investors should be aware of when looking at ETFs. One of the most commonly cited problems is that of tracking error. This is a disparity between the value of the underlying assets and the returns of an ETF. This usually remains at a small percentage, but can widen and tends to be more of an issue when the fund invests in illiquid assets. Illiquidity and transactions costs are often cited as the main cause of tracking error. As with all investments the key is to understand the nature of the investment that is being made.