What is an Exchange Traded Fund (ETF)?

Exchange traded funds, or ETFs, have become one of the most popular ways to invest. In fact, ETFs let you invest in pretty much any type of investment you can think of.

Here we look at what an ETF is, how an ETF works, its various different types, how ETFs compare to other sorts of investment funds, and how you can invest in them.

What are ETFs?

An exchange-traded fund (ETF) allows you to invest by buying many stocks or bonds at once. They have a lot in common with other types of investment funds like open-ended funds or investment trusts. Many ETFs allow you to invest in the stock market, but there are also ETFs that invest in bonds, commodities, property, foreign currencies and so on.

At their simplest level, ETFs pool together money from all different sorts of investors and then use that money to invest in a particular type of investment. Therefore, you could use them to invest in UK smaller companies or US cloud computing firms or Chinese corporations. Rather than choosing a few companies in an industry or sector, an ETF allows you to buy the lot in one fell swoop.

Essentially, they allow investors to hold a wide range of investments at a very low cost, certainly much more cheaply than they would be able to do themselves.

How do ETFs work?

Most ETFs follow the price of an index. An index is simply a method of following the price of a certain predefined set of investments.

For example, the first UK ETF that was launched tracked the FTSE 100, a well-known index that follows the fortunes of the largest 100 companies listed on the London Stock Exchange. So this ETF owns a little bit of every company in the FTSE 100, according to their current weighting in this particular index.

ETFs are traded on the stock exchange, so their price moves up and down over the course of the trading day and you can buy them using a broker in a very similar way to buying shares in a publicly listed company. You buy and sell ETFs in individual units.

There are some nuances to be aware of, as you would expect. Most ETFs will hold their investments directly and these are referred to as physical ETFs. However, some ETFs invest in products called derivatives that are designed to mimic the price movements of an index instead — these are known as synthetic ETFs. Synthetic ETFs tend to be riskier especially when markets are moving rapidly.

Most ETFs are passive and hold their investments according to what’s in the index they are designed to track. But there are some active ETFs where a fund manager decides what investments to buy and sell instead.

Types of Exchange Traded Funds

There are a few different types of ETFs to be aware of.

Index ETFs

An index ETF is an exchange traded fund designed to track the price of a particular index. Usually, the index will be following the price of a set of shares, but you can also get indices that track the price of groups of bonds, commodities or other assets.

Bond ETFs

Bond ETFs allow you to track the returns of a set type of fixed-income securities such as government or corporate bonds.

Commodity ETFs

If you want to track the returns of gold, oil, copper, or another type of commodity then a commodity ETF might appeal. Be aware that many commodity ETFs don’t hold the underlying asset, investing instead in a financial product that tracks the price of the commodity instead.

Currency ETFs

Currency ETFs allow investors to bet on the price movements of one individual currency against another, such as the pound against the US dollar.

ETFs vs. Mutual Funds: what’s the difference?

ETFs and mutual funds (or open-ended funds as they are often called in the UK) have a lot in common.

The main difference is that an ETF trades on a stock exchange, so its price changes throughout the day and you can buy and sell ETFs at any time that particular stock exchange is open.

Mutual funds, however, only have one price and one trading point each day. Therefore, all the buy and sell orders for any particular day are grouped together and put through at the same price. ETFs, therefore, give you a little more control over the timing of any purchase or sale.

How much money do you need to be able to invest in ETFs?

You don’t need much money at all to invest in ETFs as you can buy a single unit to get you started, potentially getting you a well-diversified portfolio for less than £100.

The unit price of individual ETFs can vary quite a lot, from a few pounds to a few hundred pounds, so that can be a limiting factor, depending on what you choose to invest in, as few brokers currently allow you to buy fractional units of an ETF.

Fortunately, there is no stamp duty tax when you buy an ETF (most company shares and investment trusts listed on the London Stock Exchange incur a stamp duty charge of 0.5% when you buy them) so that’s one cost you don’t need to worry about.

You will need to pay your broker’s commission charge, just as you would if you bought shares in an individual company. This could be anything up to £12 per transaction although you can reduce the cost if you choose a regular investment plan or an app that offers free trading on a restricted range of shares and ETFs.

Pros and cons of investing in exchange traded funds

Pros

  • Variety of investment options – Arguably the best thing about ETFs is the sheer variety of investment options they now provide, allowing investors to buy a diversified portfolio at a very low cost in just a few clicks.
  • Ability to buy or sell instantly – The fact that they can be bought and sold instantly appeals to many investors, as it gives you certainty about what you’ll pay or receive.
  • You can put them in tax-protected accounts – You can also put ETFs into tax-protected accounts like ISAs and SIPPs, which means that you should not have to pay any income tax on dividends or capital gains tax on any profits.

Cons

  • Can be overwhelming to new investors – The variety of ETFs on offer may not always be a good thing, however. It can be easy, especially if you are still learning about investing, to get drawn into a fairly niche ETF that sounds glamorous but may not actually be that well diversified. It makes sense to check the factsheet for the ETF to get an understanding of how big it is (as smaller ETFs may be harder to trade) and what its underlying investments are.
  • Price variation – The price of ETFs can sometimes vary from the prices of the investments or index that they are tracking, particularly in the case of synthetic ETFs, which we mentioned above. This tends to happen a lot more when markets go through a period of increased volatility, with prices moving much more than they normally do.

How to invest in ETFs

There are three steps to get started with investing in ETFs:

1. Decide what sort of investments you want to buy

The first step in investing in ETFs is deciding what sort of investments you want to buy in the first place. So are you interested in a global index tracker, following world stock markets, or do you want to drill down into specific regions, countries, industries, or company sizes?

Once you have decided upon that, you can then look for individual ETFs that track the section of the market you are interested in. The same goes for other types of ETF that invest in bonds, commodities, and currencies.

If you are interested in a popular market like the US and UK, you may find there are several ETFs on offer, so you may need to choose one based upon its annual cost, size, the reputation of the ETF provider, and so on.

More specialist types of investment may only have a few or perhaps just one ETF; however, you still need to look under the bonnet to check what you’re buying matches up with what you would like to invest in.

2. Get a broker

You can use our list of top-rated share dealing accounts to choose a broker that works best for you. You’ll need to open an account, enter some personal details, and then put money into your account to fund any purchase.

3. Start trading

Once your account is up and running, you can log in and buy your ETF online. You can either enter the full name in the search box, use a search filter offered by your broker, or enter the ETF’s ticker code. A ticker code usually consists of three or four letters, such as ISF for the first iShares ETF that tracks the FTSE 100 or VWRL for Vanguard’s global markets ETF.

You’re ready to invest in ETFs

Now you know what an ETF is, how they work, and how to invest in them. You’re ready to get started!

But identifying the best investment opportunities requires long hours of in-depth research. And having a true ‘edge’ can make all the difference to your portfolio’s returns, especially during a bear market like this one.

6 shares that we think could be the biggest winners of the stock market crash

The hotshot analysts at The Motley Fool UK’s flagship share-tipping service Share Advisor have just unveiled what they think could be the six best buys for investors right now.

And while timing isn't everything, the average return of their previous stock picks shows that it could pay to get in early on their best ideas – particularly in this current climate!