Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.
Exchange-traded funds – or ETFs as they’re known for short – have a reasonably self-explanatory name.
Firstly, they’re funds. This means when you invest in them, you’re investing in multiple assets via a single trade. Your money is often exposed to the performance of many companies rather than just one stock.
Secondly, they’re exchange traded, meaning you can purchase shares of ETFs just as you would purchase shares of a company’s stock. They trade on major exchanges like the London Stock Exchange and can be bought and sold at any time during regular trading hours.
How do ETFs work?
As with other fund products, when you buy a share of an ETF your money is pooled with that of other investors. This is then used to purchase assets that make up a portfolio. Which assets get bought depends on the investment strategy of the ETF you buy into.
"If you’ve explored ETFs in any way, you’ve probably come across products that track popular stocks indexes like the FTSE 100 or S&P 500."
Many ETFs are indexed products. This means they try to closely track an index of securities with the goal of replicating its performance. That’s a contrast to actively managed fund products, which involve a manager picking assets to invest in and making decisions on when these are sold.
If you’ve explored ETFs in any way, you’ve probably come across products that track popular stock indexes like the FTSE 100 or S&P 500. When you buy a share of these products, your investment is spread across the stocks that make these up. The performance of your investment will closely replicate the performance of these indexes.
The holdings in ETFs will periodically be adjusted so that they continue to represent the tracked index. This process is known as rebalancing, which we’ll cover in a subsequent Learn article.
"The world of ETFs is enormous. Providers of these products have looked to track the performance of everything from large-cap global stocks to cannabis companies."
What do ETFs invest in?
The world of ETFs is enormous. Providers of these products have looked to track the performance of everything from large-cap global stocks to cannabis companies.
A non-exhaustive list of types of ETFs you may encounter is below:
Stock ETFs based on well-known equity indexes – such as the FTSE 100, S&P 500 or the MSCI World Index.
Fixed-income ETFs tracking bond indexes, looking to replicate the performance of sections of the global bond market
Single-country ETFs that follow indexes comprised of stocks from an individual country. You can also find ETFs focused on stocks in different regions, like Europe or Asia-Pacific.
Sector ETFs, which track stocks representing a particular industry. For example, you can invest in funds focusing on pharmaceutical, industrial or technology stocks.
Thematic ETFs, which invest across sectors in order to capture the upside of an emerging trend or theme. There are ETFs, for example, that invest in companies they think will meet the needs of ageing populations.
Commodity ETFs, which look to offer a replication of the performance of commodities like gold or oil.
We’ll address these in more detail in a future Learn article.
"Outperforming the market by picking stocks is hard to do – many professionals don’t even manage this."
What are the benefits of ETFs?
There are a few often-cited reasons why investors would opt for an ETF over picking their own stocks. These include:
Greater diversification – With an ETF you can gain exposure to hundreds of securities in a single trade, allowing you to create a more diversified portfolio. This means you’re not as vulnerable if one stock suddenly starts performing poorly because your money is spread across multiple investments.
Investing in the market – Outperforming the market by picking stocks is hard to do – many professionals don’t even manage this. Trying to capture the returns of the broad stock market, therefore, can be a viable investment strategy. Investing in an ETF tracking a large-cap stock index – like the S&P 500 – allows you to do just this.
Of course, stock market performance fluctuates, so you’ll need to be comfortable taking the rough with the smooth.
Fewer transactions fees – If your broker charges you commission when you purchase stocks, you’ll pay this every time you trade. You may also be subject to other fees – like foreign exchange charges – when purchasing certain securities. These can add up, so being able to access multiple securities in a single trade via an ETF can help reduce costs.
Additionally, there are some benefits of ETFs over other fund products. These include:
Lower expense ratios – ETFs typically charge lower expense ratios than other investment products like actively managed mutual funds.
Intra-day trading – As noted above, you can buy or sell a share of an ETF at any time while the market is open. This differs to some other investment products which have a slightly more regimented process should you want to redeem your money.
There are, of course, some advantages other investment products have over ETFs. We’ll be comparing the various types of fund products – including ETFs – in a later Learn article.
What fees are associated with ETFs?
Of course, the benefits of ETFs don’t come without a cost. If you’re investing in these products, you can expect some additional fees stemming from the following:
Expense ratios – Providers of ETFs charge a fee based on a small percentage of your holdings. This covers the cost of managing the fund, custodial costs and other operating charges.
Bid/ask spread – This is not technically a fee, but it is a cost worth knowing.
The bid/ask spread is the difference between the maximum price people are willing to pay to buy a share in an ETF and the minimum price people are willing to sell it for. The larger this number, the more it can eat away at returns since you’ll be buying into the fund at a price higher than the net-asset-value of its holdings.
It’s often overlooked by investors because it is “baked in” to the price you pay when buying shares of an ETF.
As with other investments, you may also be charged:
Commission – If your broker charges commission on trades.
Foreign exchange fees – If shares of your ETF are priced in a foreign currency.
You can read more about investment fees in our Learn article here.
Capital at risk.