What is an ETF ISA?
ETFs (Exchange Traded Funds) are funds that track the performance of a specific index of stocks, such as the FTSE 100. They are traded on a live stock exchange, like a share, and have low ongoing charges compared to managed funds.
An ETF ISA is a Stocks and Shares ISA account that can hold ETFs. Not all ISA providers will be able to hold them as they are complex investments, and some may be able to hold a broader range of ETFs than others.
Along with varying charges and other accounts features, it is important to compare ETF ISAs before you decide which to choose.
How do ETFs work?
An ETF will purchase each share within a particular index, for example, the FTSE 100, meaning that the performance is directly linked to the performance of that index.
Each investment will have a weighting in line with the actual index to assure the accuracy of performance.
An ETC (Exchange Traded Commodity) will track a commodity instead of a share index. The value of anything from gold to oil, to coffee, can be tracked via an ETC.
Do ETFs pay dividends?
The underlying shares that ETFs hold will pay out dividends to shareholders in the usual fashion and the treatment of these dividends depends on the ETF type.
Like other funds, ETFs are categorised by either income or accumulation ETFs. Income funds will pay out dividends to shareholders, while accumulation funds will automatically reinvest the dividends into more share purchases.
What are leveraged ETFs?
Some ETFs will also apply leverage to the fund to increase the volatility of the holding. If a fund is leveraged by 200%, for example, then any movement in that index or commodity will be doubled in the performance of the fund.
This means that any gains and losses are multiplied by a factor of two. ETFs that use leverage are classed as sophisticated investments and you might need to complete a questionnaire to be able to hold them in your ETF ISA account.
In addition, some ETFs will ‘short’ an index or commodity (e.g., -200% leverage), which means that all returns are reversed and multiplied for that index. Make sure you read the product literature and fully understand the ETF before you invest.
What are the benefits of an ETF ISA?
Any investments you hold in a Stocks and Shares ISA are tax-free, so if your ETF investments increase in value, you will not have to worry about paying Capital Gains Tax when you sell them.
You also will not need to worry about paying income or dividend tax on the dividends generated by the ETF. If you hold an ETF outside of an ISA then you need to declare all of the income it generates on your tax return. With an ETF ISA, however, these are all tax-free.
Investing in ETFs can be very lucrative. They can significantly outperform the best returning Cash ISAs, particularly over the long term.
However, with potential returns come potential losses, and the risks are also a lot greater. Even the most experienced investors can lose money on ETFs, so you need to understand and be comfortable with the risks involved.
3. Lower Charges
Most ETFs have lower ongoing charges than managed funds because they require much less work to manage.
An ETF manager will still need to administrate the fund and make relevant trades to keep the ETF accurate. However, they do not need to hand-pick the investment themselves.
They do not need to research the market, ascertain risk weightings for certain investments, or even worry about the overall performance of the portfolio as a standard fund manager would.
For this reason, their ongoing charges are much lower than you would expect to pay for managed funds, but you do not get the assurance of an expert making investment decisions on your behalf.
When comparing the best ETF ISAs, you also need to think about your ISA charges as they vary from provider to provider. We will go into more detail about this later.
4. Cheap access to foreign exchanges
Say, for example, you want exposure to the NASDAQ in your Stocks and Shares ISA portfolio. If you wanted to buy some NASDAQ listed shares directly to hold in your account, you could face paying:
- Higher Exchange Rates
- Exchange Rate Commission
- Higher Dealing Fees for trading on foreign markets
However, if you buy an ETF that is listed on the UK stock exchange and tracks a particular NASDAQ index then you could avoid all of the above charges and still get exposure to the US stock market.
If you want to invest in a particular sector or index but do not want all of your money sat with one company, then an ETF is a good way to spread your investments across that market.
Investing in one FTSE100 company is arguably much riskier than investing in all of the FTSE100 companies proportionately. Using an ETF can help you avoid putting all of your eggs in one basket.
What is the best ETF ISA?
As well as choosing the specific ETF(s) that you wish to invest in, you will need to decide on the best ETF ISA provider for you. The most important factors to consider when comparing ETF ISAs are:
Ongoing Fees / TER (Total Expense Ratio)
Your ISA will charge an annual fee for holding ETFs. This is usually in the form of a percentage of your total portfolio value. Some providers might have a higher percentage charge, but a maximum cap of say £200 per year, so make sure you look closely at the terms and conditions of each account.
Some providers will charge more for buying and selling ETFs than others. Depending on how frequently you will be trading, this could outweigh the ongoing annual charges.
There are multiple ISA account features that are useful if you are trading ETFs, so you should think about which ones you want and check that your provider can facilitate them. Here are some of the key account features:
- Price Alerts - get notified about sharp price movements
- Stop Losses - automatically sell holdings at a certain price
- Limit Orders - automatically buy holdings at a certain price
- Regular Trader Discounts – pay less for trading more
- Watchlists – create a dummy portfolio to monitor without committing funds
- Research – exclusive news and insight on ETFs
How safe are ETF ISAs?
Some ETFs are arguably safer than others depending on what they track. However, this is part of what makes ETFs less safe than other investments. They are so varied and complicated that it can be easy for investors to misunderstand what they are investing in.
If an ETF tracks the FTSE100, this is a fairly stable index as it represents the 100 largest companies on the UK stock exchange. On the other hand, a smaller and more niche index is likely to be much more volatile and prices can fluctuate vastly in short periods of time.
This is why you need to be comfortable with potentially losing money, especially over the short term.
What are the alternatives to ETF ISAs?
You can invest in shares of companies directly if you think a company will perform particularly well. However, you will have a more concentrated portfolio in comparison to an ETF that will spread your investment over many holdings.
Actively managed funds are a similar asset class to ETFs in that they invest in a particular sector, index or geographical area. However, a professional fund manager will pick the underlying holdings based on a particular investment strategy, and will aim to outperform the benchmark for that market.
With the added expertise and management, you will pay higher management fees for this type of active fund compared to a passive fund like an ETF.
Some examples of managed investment funds are:
- Unit Trusts
- OEICs (Open Ended Investment Companies)
- Investment Trusts
Investing in a Cash ISA will give you the peace of mind that your investments cannot go down in value.
However, interest rates are currently so low that the returns available are not attractive to many investors. This is especially true when you factor in the negative effects of inflation on the value of your cash.