Exchange-Traded Fund: What Is an ETF?

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The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

The world of investments has exploded with unlimited possibilities over the last decade. Several types of investment and trading tools are now available at the click of a button, and this allows the public to create tailor-made portfolios factoring in the time available and risk exposure.

Right now, one of the easiest ways to give a portfolio exposure to a basket of stocks and bonds collectively is termed exchange-traded funds, or ETFs in short.

ETFs are largely considered one of the most flexible investment instruments available to modern investors. They give portfolios exposure to multiple areas that would be impossible for investors with relatively small budgets to achieve. And they have soared in popularity since they were first established in the UK in 2000. Today, the London Stock Exchange is the leading European market for ETFs, with more than 1,500 ETFs worth over £110bn+ listed on its platform.

Below, we’ll analyse the basics of ETFs, why they work as an investment tool, and the various types available right now. For beginner investors, this guide can be a starting point for exploring ETFs in the UK and how to pick them.

What is an ETF?

An ETF is a collective investment instrument that allows people to invest in multiple stocks, commodities, bonds, property, and foreign currencies, sometimes at once. 

Much like open-ended funds or investment trusts, they are compiled by large private asset managers. They can be focused on a particular sector, like energy stocks, or just focused on top stocks in an index like the FTSE 100. The possibilities are almost endless. 

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. Exploring a sector, its top stocks, average returns, and business fundamentals is time-consuming and could frazzle the average investor. ETFs address all these issues. 

Let’s say an investor is looking at the UK real estate sector as a potential opportunity. Studying the top companies and trading individual stocks would be time-consuming. The trading fees mount up quickly as well. Instead, the investor could buy into a real estate-focused ETF that will spread a lump sum over a range of stocks picked and divided based on a host of factors including size, role, and potential returns. All this involves researching one investment and one transaction.

How do ETFs work?

Asset managers create an ETF, usually centered around an index or an industry. They pick stocks, bonds, and commodities they think will be a good fit, decide the allocation for each, and then offer them to the public for purchase, much like stocks. 

For this reason, most ETFs follow the price of an index. To avoid constant shuffles and changes, they simply follow the price of a certain predefined set of investments.

For example, the first UK ETF 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. Its current sector-wise breakup includes: 

  • 19.1% in consumer defensive stocks
  • 16% in finance stocks
  • 13.6% in energy companies
  • 12.6% in healthcare stocks

So, purchasing this ETF would give a portfolio exposure to FTSE 100 shares predominantly (over 50%) in these UK market sectors.

ETFs are traded on the stock exchange, much like any other listed share. Their prices move over the course of the trading day and can be purchased using the most common trading platforms just like any other share. Investors can buy and sell ETFs in individual units, choose to set up a systematic investment plan (SIPs), step-up periodically, or put in a one-time lump sum.

There are some diverse ETF types as well. While most ETFs are passive and track the parent index, some are actively managed by fund managers as well. It is important to understand the distinction between the various types and understand the claims and what a particular ETF is designed to do. 

Let us look at the types of ETFs in greater detail. 

Types of ETFs

Index ETFs

An index ETF is 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 indexes 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

For investors looking to target commonly traded materials like gold, oil, copper, lithium or another type of commodity, a commodity ETF could be a great choice. 

Be aware that many commodity ETFs don’t hold the underlying asset. This means that buying a commodity ETF does not entitle investors to physical gold or copper. Instead, it is a financial instrument which tracks and moves alongside the prices of these commodities. 

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. Given that currency values can fluctuate greatly over time, these ETFs are popular as well.

Synthetic ETFs

Some ETFs invest in products called derivatives that are designed to mimic the price movements of an index — these are known as synthetic ETFs. Synthetic ETFs tend to be riskier especially when markets are moving rapidly.

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. People can buy them throughout the day and the price fluctuates, much like any other share. The price of an ETF is determined based on how the primary index/stocks perform that day. 

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.

ETF vs. index funds: what’s the difference?

By now, you know what ETFs do. Index funds are slightly different in that they primarily track the price movements of a particular index instead of a select group of stocks. 

They track and move according to a specific, pre-determined index like the FTSE 100 or the NASDAQ

The main difference between an ETF and an index fund is the time at which you can purchase them. An ETF is available for trading throughout the day and the prices keep fluctuating, exactly like a listed stock. An index fund is available only after a day’s trading is closed. Once the stock prices are determined for the day, the index price is generated and made available for trades, usually after 4 pm. 

Advantages of investing in ETFs

1.   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 low cost in just a few clicks. This enables investors to explore a range of stocks, styles, and sectors in a relatively short span, making it a valuable teaching/data collection tool as well. ETFs can help investors track the performance of various industries over the mid or long-term. 

2.   Ability to buy or sell instantly 

The fact that they can be bought and sold instantly appeals to many investors, as it gives investors certainty about their transactions. ETFs can be bought and held or traded in short spans when they hit the desired price. This flexibility sets them apart from some other ‘basket’ investment tools. 

3.   Returns can be tax-protected

You can also put ETFs into tax-protected accounts like ISAs and SIPPs, which means that they could be exempt from any income tax on dividends or capital gains tax on any profits. If an investor is looking to work towards early retirement, this combo could theoretically help rake in tidy profits after decades of holding and increasing positions in a successful ETF. 

Disadvantages of investing in ETFs

1.   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 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.

Exploring ETFs is easier when you have a fundamental understanding of the market, what corrections are, P/E ratios, and industry knowledge. 

2.   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 market volatility, with prices moving much more than they normally do.

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 — 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, 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.

Do ETFs pay dividends?

Since the companies that run ETFs receive dividend payouts from stocks on their ETF basket, most modern ETFs offer shareholders a payout based on the number of units they own. These are paid out annually, half-yearly, or on a quarterly basis depending on the ETF. 

Different ETFs come with different dividend offer rates. While there is no guarantee, funds try to create a portfolio that is capable of hitting targets. However, poor market performance could affect returns. 

Before investing in ETFs, it is crucial to consider the dividend payouts on offer and calculate your projected payouts based on holding size. If an ETF pays a dividend, all information is generally available on the ETF site. Investors should access this information before making a decision. 

Are ETFs safe?

Much like any other investment, ETFs do carry a risk. But analysts do look at them as an investment with a lower risk profile. This is because a majority of ETFs just track an index and try to match its returns.

If one company in an ETF basket performs poorly, it could be offset by stronger returns from another. Whereas, if a company you invested in directly posts consistently poor results, it is almost a certainty that the share price will fall. 

For this reason, ETFs are seen as relatively safe investments for people expecting modest returns over a long duration. But this is not true for all ETF types. Leveraged ETFs try to double or triple the returns of their base index through financial derivatives or debt. By introducing extra funds, the ETF tries to boost its value. These are generally considered riskier than traditional ETFs. 

It’s very important that investors do their due diligence and study the fundamentals of an ETF before investing. If an ETF includes international stocks and bonds, it is important to know the economic climate in that region as well. Gleaning a general outlook about the economy you are investing in is also important to gauge returns and not panic when returns reduce. 

How to invest in ETFs

There are three main steps to 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. 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 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 ETFs 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.

Which ETFs should you buy in the UK?

Given the popularity of ETFs in the UK, investors have a variety of offerings to choose from. Top global asset managers like Vanguard, State Street Global Advisors, and Invesco all have UK-specific ETFs. But, in the modern world, we do not need to be restricted by geography. ETFs that track global indexes are also available to every investor in the UK. 

So which ones should you buy? Well, that will depend on your financial goals, risk appetite, and more. We recommend research-based, long-term investing. 

Having a fundamental knowledge of sectors, companies, and economic health is crucial to analyse the future potential of an ETF. If there is a particular area, like gold stocks, that you are bullish on, look at the top ETFs in that industry to find an ETF for you. Read through the fine print carefully, see what the claims are and the projected returns and companies/indexes it tracks. This first step will help narrow your search down, making the process much easier.

If you are a beginner, looking at basic index ETFs like the FTSE 100 tracker is a good starting point. These ETFs are pretty straightforward and are easy to keep a track of given you only have to analyse the performance of the whole index instead of numerous individual companies. 

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Frequently Asked Questions

When a company lists its IPO and sets a value to be derived from the offering, this is fixed. After all the allotted shares are purchased, the company takes the money as a one-time transaction. Now the shares are still available for trading. If an investor chooses to sell their holdings, only another investor can buy them. Once the initial offering is sold, the stock is ‘closed’ for the company. This makes the stock a close-ended fund.

But ETFs and mutual funds are slightly different. If an investor sells their holdings in an ETF, it is brought back by the fund’s management. This makes them open-ended.

Most ETFs you can buy in the UK and worldwide are passively managed as they track and move according to the underlying index they represent.

But there are many actively managed ETFs. They are managed by a team of ‘fund managers’ who make constant trades in the basket of stocks the ETF covers. They account for market stability, make allotment changes and notify shareholders of the changes as well.

If you are looking to invest in ETFs, make sure you are picking what you want. Most passive ETFs offer returns comparable to the indexes. But actively managed ETFs state different rates of returns depending on a multitude of factors. Even these figures are just rough estimates which can vary with market health and company performances.

ETFs trade exactly like stocks. This means that traders can place short or long positions on ETFs throughout the day, much like with stocks. In fact, many day traders focus only on ETFs as they have a functional knowledge of a particular sector with which they try to predict the direction in which a listing could move in the future.

Therefore, you can short ETFs on your preferred trading platform.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.  

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a "top share" is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a "top share" by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.