How ETFs can help in building a diversified equity exposure

Exchange traded funds are an efficient way of gaining exposure to equity indices while maintaining liquidity, according to advocates of the structure.

ETFs can track a market index, providing investors with diversification across the whole or part of a market. 

In terms of diversification, one ETF can give investors access to hundreds of stocks. Index ETFs are designed in a way that replicates the performance of a benchmark index, like the FTSE 100 or S&P 500. 

Read the full guide to ETFs here

Senior research analyst at AJ Bell, Terry McGivern, says ETFs track indices in a “simple and efficient way”. 

David Batchelor, senior fund analyst at Quoted Data, says the equity ETF market remains larger than its fixed income counterpart. 

“It is a well-established means of gaining exposure to equity indices in a low cost and highly liquid way, without having to buy each constituent share. 

“Investors can gain index-wide exposure with the flexibility of owning a single security.” And as well as allowing investors to gain access to indexes, ETFs can be efficient in providing exposure to individual themes. 

Batchelor adds: “Thematic ETFs offer exposure to a specific trend or sector, from clean energy to AI, through a specifically defined basket of companies, without the need for extensive research of the whole market.” 

A challenge here is that quite often thematic investments, regardless of the structure, are brought to market during a period of excessive hype about the asset, which may be a trend of the moment, rather than a long-term opportunity.

George Mantilas, chief operating officer at Trading 212, says the range of different ETFs is attractive to investors who want variety in their portfolios. 

“ETFs are popular with investors for that transparency, that low cost and the fact that there’s a nice variety. 

“So, depending on what it is that you’re interested in or want to gain exposure to, you can.”

There are also ETFs out there that exclude mega caps, which could help investors nervous about concentration risk. 

This has become more of a concern in the past year or so, with technology and AI pushing the top stocks in major indices to record market shares. 

“One of the big issues you’ve got in the US at the moment is that a handful of companies have dominated the returns of the index,” says McGivern. 

“One of the benefits of passive investing and investing in indexes, is that you’re getting broad diversification, but you don’t just want diversification of names, you want actual, genuine investment diversification.” 

McGivern says more choice was important but warned there is a risk of “analysis paralysis” if retail investors had too much choice. 

Currency risk

Investing in overseas markets comes with currency risks, with the potential for investment losses due to changes in exchange rates. 

McGivern says this can be mitigated through using a hedged ETF, which uses financial instruments to reduce or eliminate the risk. 

“The currency risk of investing in overseas markets can be managed through buying a hedged ETF, so the only exposure is to the share price moves of the underlying companies.” 

He explains: “If you are buying an S&P 500 ETF, for instance, obviously all of the performance and everything that it earns in dividends and exposure is all dollar based.

“If you’ve owned it and the S&P 500 has gone up but sterling has also gone up you will get less for your money when you convert it to your home currency.” 

“So, if you own a currency hedged share class of that, what the manager will be doing is running a [currency forward] on your behalf within the ETF, and that’ll be trying to immunise and keep the dollar value in line with GDP. 

“So then you get a more pure exposure to the S&P 100; you are not mixing currency and investment returns in one big pot.” 

Trading 212’s Mantilas says ETFs can also help mitigate the currency risk as they offer equivalent funds quoted in different currencies, as they are listed on different markets.

He says: “You can have the same ETF, but quoted in three different currencies. So if you want to trade the sterling one, you can, even though it’s got links to US assets, for example, but it will be quoted in GDP so that is factored into the ETF pricing.” 

That pricing differential may also represent an arbitrage opportunity, as investors can access much the same asset but at different prices.

Tara O’Connor is senior reporter at FT Adviser