Over the last 25 years, Exchange Traded Funds (ETFs) have grown in popularity. But many people are still not exactly sure of what they are, believing they can just buy a Global Equity ETF or a North American ETF. But the reality is, there are thousands of different ETFs to choose from and even two that look the same may be very different.
What are ETF’s
An ETF tracks an index of stocks, bonds or commodities. They are traded on the stock exchange so their value goes up and down throughout the day (whereas a fund is valued at the end of the day). The ETF owns the underlying assets of the index it is tracking.
One of the main reasons for their growth in popularity is the low cost of running them. As they don’t make any active decisions on which stocks to buy or sell, they don’t have to pay analysts to study companies or star fund managers to make investment decisions.
What it is tracking?
Each ETF has an index that they try to copy. These indices are created by companies such as MSCI, S&P or FTSE. You need to be aware of what they are tracking as the indices themselves can be very different, even if they sound similar. Here is an example of three of MSCI’s World Flagship Indexes
MSCI World Index: Covers more than 1,600 securities across large and mid-cap size segments and across style and sector segments in 23 developed markets.
MSCI World Investable Market Index (IMI): Covers more than 4,500 securities across large, mid and small-cap size segments and across style and sector segments in 23 developed markets.
MSCI World All Cap Index: Covers approximately 6,100 securities and includes large, mid, small and micro-cap size segments for all 23 developed markets countries.
Not only do they invest in a varying number of companies, they invest in different sized companies. These will all have an effect on the performance of the index.
Do not assume that all ETFs are the same. When deciding which ETF to purchase, it is very important to look at the tracking error of the ETF. That is, how good is the company at actually replicating the performance of the index that it is tracking. Remember, when people invest in ETFs, it is because they believe in market efficiency and want to capture the returns of the market. If an ETF has a high tracking error, they are not capturing the returns of the market accurately, and so not doing what they are being paid to do.
US v European domicile ETFs
The taxation treatment of ETFs for Irish investors are very different depending on where they are domiciled. Despite ETFs being traded on the stock exchange like any stock, in Ireland they are taxed under the “gross roll up” regime. That is, any dividends or sale of shares are rolled back up into the fund without you incurring a tax liability. Gross roll up funds are taxed at 41% on profit and you must pay deemed disposal every eight years.
US and Canadian ETFs however are taxed like shares, so deemed disposal does not apply and gains are taxed under Capital Gains Tax which is 33% on profit less the annual exemption of €1,270. The reason for this is that US and Canadian ETFs pay out dividends every year which are taxed as income. The Revenue are happy to get some tax income each year and so tax these ETFs under the CGT tax system.
Recent European legislation has prevented lots of people from investing in US or Canadian ETFs. From the beginning of 2018, regulations state that anyone investing in a ETF or fund has to be given a Key Investor Information Document (KIID) before they invest. A problem arises however with US/ Canadian ETFs. As they are domiciled outside of the EU, they do not produce KIIDs so they cannot be sold on the retail investor market in Europe. The fund managers have no intention of producing them. Most ETF providers have European versions that satisfy EU regulations but are taxed at 41%.
A traditional ETF will own the actual underlying assets that they are tracking. But with a Syntheric ETF, they try to replicate the returns of the index by using derivatives and swaps to track the index.
On the plus side, Synthetic ETFs usually have a lower tracking error when compared to ETFs that buy the underlying assets. They tend to be cheaper to run, so the cost to the consumer is lower.
However, the ETF provider has to enter into an agreement with a third party to pay the return of the index. While that third party is usually a bank, it does add a layer of counterparty risk that doesn’t apply where the fund is buying the assets themselves.
So, before you go and buy ETFs, it is vital that you know what the ETF is actually tracking; what companies make up the index, how many are in the index and what size are the companies. Also when deciding what provider to use, how has their fund performed in comparison to the index they are tracking. All providers will make this information freely available.
Author: Steven Barrett is the Managing Director of Bluewater Financial Planning, www.bluewaterfp.ie