Investors offered a way out of the gloom

It can be frustrating being a small private investor, hunting for decent returns amid the rubble of equity prices and savings rates. Any hot share tips are often kept to a tight circle of City insiders, new stock issues are sold exclusively to the big institutions and access to investments in some of the world’s fastest-growing economies are out of reach. As for commodities, it’s not practical for the man on the street to go and buy oil, coffee or wheat.

But there is one vehicle that gives the private individual – whether they have a few thousand or a few hundred thousand to play with – access to all sorts of unusual investments. This is the exchange traded fund. On a simple level, an ETF is an alternative to an index-tracking unit trust, but according to David Kuo, investment specialist at financial website Fool.co.uk, the funds offer almost unlimited variety.

“ETFs started out by tracking large share indices like the FTSE or Nasdaq, then the emerging markets of China, India, Russia and Brazil. Now you can track just about any index from the Bolivian stock market to oil, gold and the price of wheat,” he says.

A report from Barclays on the ETF market, released last week, reveals that there are now 1,600 funds available to buy, with a couple of new ones coming on-stream each month. The big providers of ETFs include Lyxor, Barclays’ iShares, Deutsche Börse’s x-trackers and Invesco PowerShares.

ETFs are classed as a share and so can be held in an individual savings account. It is possible to put up to £7,200 each tax year in an equity ISA, and returns will be tax-free. And buying an ETF is very straightforward as they are traded in exactly the same way as shares bought and sold on the stock market by brokers. This, says Darius McDermott from independent financial adviser (IFA) Chelsea Financial Services, has its advantages and disadvantages. “The market is very liquid, so you can buy and sell ETFs almost in an instant. But stockbrokers do incur fees each time you buy or sell.

“You pays your money, you takes your choice,” he continues. “If you only have a small sum to invest in ETFs then the trading fees can swallow up quite a proportion. On the other hand, if you buy a fair few thousand then shelling out a fee of £10 or £15 a time is not going to make much difference.”

The funds themselves don’t charge much, when compared to standard unit trusts. “These are a low-cost investment. Expect to pay an annual charge of 0.2 or 0.3 per cent,” says Ben Yearsley at IFA Hargreaves Lansdown. “By contrast, an index-tracking unit trust typically charges 1 per cent annually.”

ETFs look even cheaper next to actively managed funds – ones that have a manager at the helm making daily stock picks rather than simply tracking moves in a particular index. Upfront fees here can range from 3 to 5 per cent, although these can often be reduced if the fund is bought through a fund supermarket.

In these straitened financial times, many of the old investment orthodoxies are under attack, such as the idea that shares are the best way to secure long-term growth. Over the past decade – with some volatile moves up and down in that time – any investment vehicle tracking the equity indices of the major Western economies and Japan has been a loss maker. For example, the FTSE 100 stood very near the 7,000 mark at the end of the millennium; today the level is closer to 4,000. That is some drop and it may be a long time before it is made up.

It is no surprise, therefore, that traditional unit trusts have suffered a sharp drop in interest, with investors acquiring an appetite first for property, then bonds and now, increasingly, commodities.

“ETFs are the most efficient way for small investors to get access to commodity markets,” says Mr Yearsley. “As a private individual, you can’t buy wheat futures or oil. Even gold investors have the problem of storing it and the dealer fees can be high. So instead you can buy an ETF which tracks a particular market.”

Mr Kuo adds: “ETFs allow you to build a much wider, more diverse investment portfolio than used to be the case.”

However, trading in commodities comes with serious financial health warnings. “It is one of the highest-risk investments you can undertake – more so than shares or property. Frankly, in the risk stakes it’s a 10 out of 10,” warns Mr McDermott. “Take the oil market, for instance. If you had bought oil in the middle of last year, you’d now be sitting on losses of close to 80 per cent. A lot of institutions piled into oil at that time and are now counting the cost.”

Mr Yearsley agrees that commodities aren’t for everyone. “You should only have a small part of your portfolio in this sector and you shouldn’t go for anything of which you have no knowledge. For example, there is plenty of information out there on the gold or oil price, but you’re not going to know about the more esoteric markets in the agricultural sector unless you’re involved in it day to day.”

Furthermore, commodity prices have suffered in the global downturn. The stellar growth of China and India has slowed and with it the demand for raw materials, which in turn has affected their price. Longer term, though, when these economies rebound, it is likely commodities will start to take off again.

But it’s not just commodities to which ETFs grant better access. “Investing in some smaller emerging markets and small specialist sectors of the stock market, like biotechnology, can be difficult through a traditional unit trust and you may have to rely on a fund manager – and evidence shows that more often than not they underperform the market,” says Mr Kuo.

But what role should ETFs play in a small investor’s portfolio? “These funds are a passive tracking investment, and this is generally a good thing,” adds Mr Kuo. “My ideal is to have a smattering of index-tracking funds and ETFs, mixed in with some carefully chosen individual shares to give a performance boost.”

But Mr Yearsley says it’s not as simple as investing in ETFs or actively managed funds. “You need a bit of both. I accept that the majority of fund managers underperform – there is a lot of rubbish out there. But there are still 200 to 300 which overperform, and that is a big universe to pick from.”