Using Exchange Traded Funds in your portfolio

'Passive' Investments

Investors who wish to use low cost 'passive' investments that are not actively managed and aim to track an index rather than attempt to outperform it, may choose to use ETFs. Investors could use a mainstream ETF such as a FTSE 100 ETF as a core holding and then use higher risk more specialised ETFs to add further diversity to a portfolio.

Short Term/Strategic Investments

The majority of investments are used as long term investment vehicles but in some cases ETFs and in particular ETCs may be used as a short term investment or strategy. For example, you may think that the price of gold is going to rise in the next 3 months and may therefore invest in a gold ETC with the intention of selling the investment again in the near future once your price target has been reached.

Benefit from falling prices

If on the other hand you think that the price of gold is going to fall, for example over the next 3 months, you could purchase a short gold ETC. A number of short ETCs were launched at the end of February 2008, followed by the first short FTSE 100 ETF a couple of months later. Short ETCs work on the principle that if the price of the underlying commodity/index falls by 1% during a day then the corresponding short ETC will rise by 1% during a day (excluding costs) and vice versa. Because the short works by matching the daily percentage movement in the price of the underlying commodity/index, for periods of more than one day it is possible for a Short Security to ''outperform'' or ''underperform'' the relevant index or commodity.

Short ETFs could be used as an investment tool to protect gains already made by another investment or just to gain from a drop in the price of the relevant index or commodity. For example, someone who has made gains in oil company shares and retains a high exposure to equities in the oil sector might wish to buy a short crude oil ETC to 'protect' some of those gains. If the price of oil falls, oil shares (such as BP or Shell) may fall as well, however the short oil ETC will rise thus offsetting some of the losses elsewhere. It is worth pointing out that shares in oil companies are not always affected by the price of crude oil in the short term.

Leveraged/Geared Investments

Leveraged ETFs are a recent addition to the ETF universe. They are very high risk and are intended for use by institutional or sophisticated investors. Please view the individual prospectus for a leveraged ETF to ascertain who they are suitable for and the risks involved. Only investors who are willing to accept the risk of losing all of their capital should consider these investments as capital can be lost at a much quicker rate and a couple of wrong positions could lead to very quick losses. Most leveraged ETFs work on a double leverage basis so that if the price of the underlying commodity/index rises by 1% in a day then the corresponding ETC/ETF will rise by 2% in a day (excluding costs) and vice versa. The percentage movements of a leveraged ETF are also calculated on a daily basis meaning that for periods of more than one day it is possible for a Leveraged Security to ''outperform'' or ''underperform'' the relevant index or commodity.

Investments unavailable elsewhere

Direct investment in countries such as Brazil, China and other emerging economies is often inaccessible without the use of a managed fund. The same is true for commodities. In some cases it is difficult and in others it is nearly impossible to gain direct access to commodities without using an ETC or managed fund. Livestock, wheat and coffee are just a few examples of investments that are not easily accessible outside of an ETC.

Risks

Different types of ETF will have varying levels of risk. Any ETFs, such as leveraged and short ETFs, that do not physically hold the underlying assets rely on futures contracts and this introduces a counterparty risk. Please see the Risks of ETFs section for further details.