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Fair exchange

Exchange-traded funds are a recent phenomenon in the UK and Europe – for retail and institutional investors.

Put simply, ETFs are funds traded on a liquid stock exchange like a share. They can be bought and sold like any other shares listed on a stock exchange but provide instant exposure to many companies. They combine the flexibility and tradeability of a share with the diversification of a fund.

For the moment ETFs should be viewed primarily as index trackers but with added benefits. It should also be stressed that ETFs are fully eligible for investment within Peps, Isas and Sipps.

You are able to buy and sell shares in an ETF through a broker or financial adviser. They are effectively a hybrid of an open-ended fund (unit trust) and a closed-ended fund (investment trust).

Like investment trusts,ETFs are listed on a stock exchange and can be traded whenever the market is open. Unlike investment trusts, ETFs are not closed-ended investment products and so problems of significant and sustained discounts or premiums of price to net asset value are not anticipated. In many ways, they capture the best features of both unit trusts and investment trusts – as well as providing greater transparency.

Each share of an ETF represents ownership in a fund that holds a portfolio of securities designed to track the performance of a specified index.

An example is the iFTSE 100, which trades on the London Stock Exchange. It tracks the FTSE 100 Index, with shares trading at roughly 1/1000th of the index level. If the FTSE 100 is at 3,900, the iFTSE 100 will be trading at around £3.90 per share. Performance of the shares closely mirrors the performance of the index, including dividends.

There has been much discussion about “actively” managed funds, taking the whole ETF concept directly into the field of active fund management. There are technical problems in being able to price and reprice an actively-managed fund throughout the day, as opposed to one based on an established index. But the technology is probably there to overcome such hurdles.

Possible benefits in using an ETF is to gain easy access to the world&#39s investment markets in a risk-controlled and cost-efficient manner are:

•Accessibility – you can buy them through your broker or financial adviser any time the market is open and prices are updated throughout the day. There are a wide variety of ETFs covering country, regional and industry-sector indices.

•Liquidity – if demand for an ETF rises sharply, more shares in the fund can be created to ensure the ETF reflects the prices of the stocks it holds and not demand for the ETF itself.

•Controlling cost – to achieve the level of diversification an ETF offers, you would have to buy a large number of individual stocks whilst all the time running up trading costs. There is no stamp duty to pay on secondary market ETFs and they have annual management fees as low as 0.35 per cent.

•Controlling risk – because they offer diversification, the financial equivalent of not having all of your eggs in one basket. A financial sector ETF, for example, offers exposure to an entire index of banking stocks, so if one company suffers a setback, it need not spell disaster for your investment portfolio.

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