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I’d want to run through it before going ahead and buying an exchange-traded product, and I've written it with a general reader in mind.
Some parts (for example the sections on tax and investment adviser platforms) are written from a UK perspective, but the rest is not UK-specific.
1. ETF, ETC or ETN?
While the majority of European exchange-traded tracker products are ETFs—which means they are set up and regulated like funds—Europe also has an active exchange-traded commodity (ETC) and exchange-traded note (ETN) market. ETCs and ETNs are used to track single commodities, or other, less-diversified asset classes, which cannot be structured as ETFs under the relevant European investment fund regulations.
What’s the difference? ETFs, ETCs and ETNs are all low-cost savings vehicles that track asset prices or indices. But ETFs are funds, meaning that, in the case of the bankruptcy of the promoter, assets should be safeguarded by a separate fund custodian.
Many ETNs and ETCs are collateralised, meaning that there are securities, cash, or, in some cases, physical commodities backing your savings product. Other ETNs or ETCs may not have such backing, which means that you are an unsecured creditor of the issuer and at risk if the latter runs into trouble. Check the issuer’s website and prospectus to see if there is a collateral mechanism and how it actually works.
2. Swap-based or physical replication?
Some ETFs (including most of those offered by the industry leader, iShares) use physical replication to reproduce the index return. This means that the fund manager buys all the shares, bonds or other securities in the index, or an optimised sample of them, and holds them within the ETF.
The majority of European ETF providers, however, use a process called swap-based replication. This means that an ETF will hold a basket of securities (called the collateral basket) which is unrelated to the index being tracked, and will enter into a swap contract with a third party (usually a bank and often the parent bank of the ETF issuer) which guarantees to pay the ETF the return on the index it is tracking.
Physical replication can cause tracking error, as the result of index turnover costs and the timing or tax treatment of dividends. Swap-based replication eliminates the tracking error to the index, since the swap provider guarantees to pay the full index return, but at the cost of limited counterparty exposure to the bank concerned.
Why does an investor need to know this? The rise in bank default risk since the start of the credit crunch means that investors should certainly be aware of any counterparty exposures they incur, and the different methods of index replication mean that a comparison of ETFs purely on the basis of tracking ability cannot tell the full story.
This is actually a very technical subject, once you get into it, and it’s not as simple as swap-based ETFs being riskier than those using physical replication (as some have suggested), since physically replicating funds often lend securities, and this practice can have risks of its own, collateral notwithstanding. For what it’s worth, I’d be happy to have both types of ETF in my portfolio.
3. What’s the cost?
ETFs, ETCs and ETNs carry a charge called the total expense ratio, which includes the fund manager's annual fee and certain additional costs. The TER is usually much lower than that of comparable actively-managed funds. This is one of the chief attractions of ETFs. However, if you’re planning to be an active trader of an ETF, you should check its secondary market liquidity and historical bid-offer spreads. These can vary from a few basis points (hundredths of a percent) to well over one percent for ETFs in less-liquid asset classes, in which case trading costs would be very material when compared to the fund's management fees. You should be able to find this information on the website of your country’s stock exchange.
Other costs could arise if the fund were to close, or fail to grow. See point 4.
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