Exchange-traded funds (ETFs) are an easy and cost-effective way for investors to achieve the same returns as they would from investing in an index such as the FTSE All Share or India’s “Nifty Fifty” index. Unlike tracker unit trusts, which track indices, ETFs are shares that can be bought and sold on the stock market in the same way as any other shares. Investors therefore immediately benefit from the best of both stock and mutual fund characteristics.

ETFs were introduced to Europe in 2000. Since then, they have grown exponentially in terms of assets under management, trading volumes and the breadth of market coverage.

ETFs benefit from intra-day trading at, or close to, net asset value and can give access to a whole market by the purchase of just one share. They can be bought and sold easily through your stockbroker or financial adviser.

Benefits

Diversification: Like traditional index funds, ETFs work best as a long-term investment play. ETFs offer a convenient and cost-efficient alternative to purchasing all of the underlying securities of a particular index. They are effectively an entire market wrapped up in one share as they invest in a basket of securities from a particular index so, by purchasing a FTSE All Share ETF, you are getting access to the performance of the entire FTSE index, while a commodities ETF will provide access to the entire asset class.

Cost effective: ETFs are generally cheaper than traditional funds. A typical total expense ratio of an ETF is between 0.3 and 0.4 per cent compared with about 1.6 per cent for actively managed funds. They are cheaper as they do not need to be actively managed, so investors need not employ the expertise of analysts or fund managers. It is important to note that if you buy an ETF in the UK you also escape the stamp duty charges that are normally incurred on the purchase of London-listed shares.

Real-time trading: ETFs can be traded in real time throughout the day rather than at one fixed point as with unit trusts or mutual funds. This gives investors flexibility to move in and out of their chosen index or sector according to movements in the market.

Pensions and ISAs: Investors can put ETFs into an ISA and a self-invested personal pension.

Size of the market:

The US is the largest market in the world for ETFs and is further advanced than the European market, having started in 1993. However, the European market is rapidly closing the gap. Globally, assets under management in ETFs reached $678.4 billion at the end of August 2007, with the number of ETFs having jumped to 1,026, 44 per cent higher than the number of ETFs at the end of 2006.

This year, the UK Government scrapped stamp duty on non-UK-domiciled ETFs, which opened up the UK market to foreign providers. This has significantly increased competition and the number of UK-listed ETFs – currently 75 – giving UK investors access to a whole range of asset classes and markets.

Future trends for the ETFs:

ETFs are becoming increasingly popular as the choice of funds grows dramatically and their many benefits become more apparent. As the ETF market continues to expand, investors can expect to see more specialised ETFs come to market. This will give UK investors the opportunity to access markets that, up to now, have only been able to accessible through unit trusts or OEICs.

ETFs are also likely to become increasingly popular because they allow investors to maintain exposure to equity markets while improving their liquidity – a particular attraction of ETFs given current market volatility.