Are exchange traded funds just cheap trackers?

Exchange traded funds (ETFs) are becoming increasingly popular as investors seek more products that they can trade quickly and cheaply. ETFs aim to replicate a fund structure but also trade on an exchange.

"It looks like a fund but trades like a share," says Hector McNeil, co-founder of Boost ETP. "They are very democratic. They allow any investor access to usually difficult-to-trade-on markets, currencies or asset classes at wholesale prices."

ETFs track an index or a commodity, such as the S&P 500 or gold, providing access to the commodity price or, for an index, an optimised sample of the shares within the index. The alternative would be for an investor to buy shares in a selection of the index's companies to try and create their own replica of that market.

What exactly are ETFs?

Exchange traded funds, in their simplest form, aim to replicate indices, such as the UK's FTSE 100 (UKX). A simple exchange traded commodity (ETC) tracks commodities, such as gold.

Other strategies include specific styles such as income or growth, while some versions can also "short", or sell, an asset.

But McNeil says it is not an attractive substitute; firstly it exposes the individual to a lot of specific company risk, and secondly, it will be a far more expensive exercise. An individual share purchase on an execution-only platform may cost £10, and you would have to make multiple purchases to give you a diversified portfolio.

The UK ETF market is in its infancy compared to the US, but it is growing. While more choice is invariably a good thing, many investors may be confused by the differences between, say, five different ETFs all tracking the same index. Invariably there will be little difference in their performances; ETFs are designed to match a benchmark, not outperform it - and, hopefully, not underperform it.

There will also be little difference in the portfolios; each will choose a selection of shares from the index it is tracking, so while there may be some differentiations, the core holdings are likely to be the same.

New launch

Lyxor has launched a Global Quality Income ETF (SGQL) aiming to "offer a balance between quality and yield".

The fund will track Societe Generale's Quality Income Strategy index, which comprises non-financial companies in developed markets that have a free float value of at least $3 billion (£1.87 billion). The shares will need to have scored at least seven on a 0-9 scale that looks at profitability, leverage, liquidity and operating efficiency.

It may be tempting then to go for the cheapest offering, but that is not always the best option, warns McNeil. He points to four factors he thinks investors should take into account. Liquidity is a prime consideration, says McNeil, and higher trading volumes will show that people are easily buying into and out of it, which he says should be a good thing.

The issuer is obviously something to look at; an investor should be asking who the organisation is and what does it stand for as well as deciding if they would prefer to invest with a large institution, a private bank or a boutique firm.

Next, have a look at the company website, he says. It should provide educational materials, transparency, and a clear outline of fees.

Lastly, McNeil says the tracking error (the extent to which the ETF deviates from the index) of the fund is hugely important: "It is a good indicator of any additional fees. An ETF might cost just 50 basis points but if it consistently has a large tracking error it suggests there are more costs than they're telling you."