Exchange-traded funds have taken another big step in their journey into the mainstream. As of this month, more than 500 ETFs are included in the Investment Association fund sectors.

This may sound like an arcane, technical development, and in a way, it is. But it will also make ETFs more visible and comparable with other funds, and they will now sit alongside some of the big names of fund investing, like Fundsmith, Baillie Gifford and M&G.

This will likely lead to more investors joining the growing throng of ETF converts.

WHAT ARE ETFS?

ETFs come in lots of shapes and sizes, and while in theory they are passive investments, some are only suitable for experienced investors with plenty of risk appetite.

Plain vanilla ETFs are very similar to tracker funds, in that they follow the performance of a broad market index, and do so at extremely low cost, in some cases just 0.1% or so per year.

They can also be held in ISAs and SIPPs just like traditional funds, and so have their gains and income sheltered from tax if held in these wrappers.

WHAT IS THE INVESTMENT ASSOCIATION DOING?

Savers and financial advisers will now be able to compare over 530 exchange-traded funds from the UK’s largest ETF providers within the Investment Association’s sectors. These include products from Amundi, BlackRock, Legal & General and Vanguard.

The IA sectors are widely used by investment platforms and financial advisers. They enable savers to easily navigate the open-ended fund market by dividing them into groups of similar funds.

ETF ATTRACTIONS

It is very hard for a fund manager to consistently beat the market on a long-term basis. Yes, they may have some very good years, but few can consistently sustain this outperformance during the career. Therefore, many investors see merit in simply tracking the market for a low fee, rather than paying more (in general) for someone to try and beat it.

ETFs are one of the easiest ways for you to be able to track markets. They can be traded throughout the day, giving investors greater scope to buy on market dips. By contrast, traditional tracker funds typically offered by banks and insurance companies work on a forward pricing basis, so you never know exactly what price you will pay.

Over the long term this isn’t likely to make a huge difference, but some investors like to invest part of their portfolio more tactically, and some simply want to know they can buy and sell immediately, as they can with listed shares.

ACCESSING THEMES

ETFs can also be useful to give investors specialised exposure to specific themes in the market. For instance, the iShares Automation and Robotics ETF (RBTX) tracks an index of companies involved in the robotics and automation industry.

This is where ETF investing starts to become more active than passive, because these thematic ETFs do carry higher charges than plain vanilla ETFs that simply track a broad market index.

THINGS TO CONSIDER

Investors need to pay attention to the construction of the underlying index followed by thematic ETFs, to make sure it fits their expectations.

Most investors know what the FTSE 100 is, but once you start moving away from the big market indices, you need to have a closer look under the bonnet of the ETF you’re considering.

While thematic ETFs are passive in that they track a prescribed index, the choice and construction of that index is, in a way, a bit active. By narrowing down to a certain theme, it is excluding large parts of the market.

Thematic ETFs also tend to be riskier for this reason; they won’t be as diversified in terms of stocks and sectors as ETFs tracking broad markets, like the FTSE All-Share or S&P 500. They therefore function best as satellite investments around a more diversified core, used to tilt your portfolio in a particular direction.

It’s also worth noting the availability of exchange-traded products or ETPs which are only for the most sophisticated investors, particularly those which use derivatives and leverage, which tend to add cost, complexity and risk.

MOST POPULAR ETFS

The most popular ETFs on the AJ Bell Youinvest platform over the last couple of years show that DIY investors are predominantly using ETFs to gain exposure to major markets, just as they would an index tracker fund.

Investing in gold has also been made a lot easier by products such as iShares Physical Gold (SGLN), which has been a popular pick by investors looking for a bit of ballast during distressed markets.

Clearly ETFs can perform lots of different functions, and as they rise in profile, we can expect increasing numbers of investors to take notice.

DISCLAIMER: AJ Bell is the owner and publisher of Shares magazine. Editor Daniel Coatsworth owns shares in AJ Bell.

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