What is an ETF and how do they work?

Exchange-Traded Funds (ETFs) are investment vehicles that combine the diversification of mutual funds with the flexibility of trading individual stocks. This article explains what ETFs are, how they work, their key advantages and drawbacks, and how they compare to mutual funds. Ideal for both beginners and experienced investors, it also offers practical tips on choosing the right ETFs based on your goals, risk tolerance, and market strategy.

What is an ETF?

Exchange-traded funds (ETFs) are hybrid investment vehicles that combine elements of investment funds and stocks. They aim to replicate an index and can be traded on the stock exchange like regular stocks. Unlike traditional investment funds, which are subscribed and settled at net asset value after the close of each session, ETFs have a trading symbol (ticker) and trade in real-time.

Like investment funds, ETFs invest in a basket of assets (stocks, bonds, currencies, etc.), promoting risk diversification. However, despite their internal diversification, some ETFs may face concentration risk if they focus on a single industry or niche.

Pros and Cons

How do ETFs work?

ETFs are investment funds that are traded on stock exchanges, much like individual stocks. They are designed to track the performance of an index, sector, commodity, or a mix of assets. Here’s how they work:

1. Structure: An ETF pools money from various investors to buy a diversified set of assets, such as stocks, bonds, or commodities. For example, a stock market index ETF might invest in the same stocks that make up the S&P 500.
2. Trading: Unlike mutual funds, which are bought and sold at the end of the trading day, ETFs can be bought and sold throughout the trading day at market prices. This makes them more flexible and liquid compared to mutual funds.
3. Diversification: ETFs often provide exposure to a wide range of assets, which helps to spread risk. For example, if you buy an ETF that tracks the S&P 500, you’re indirectly owning a small portion of all 500 companies in the index.
4. Passive vs Active: Most ETFs are passive, meaning they simply track an index or sector without trying to outperform it. However, there are also actively managed ETFs, where fund managers make decisions to try and beat the market.
5. Expense Ratios: ETFs typically have lower expense ratios than mutual funds because they are mostly passively managed. This makes them a cost-effective way to invest in a broad range of assets.
6. Dividends: If the ETF holds dividend-paying stocks, it will collect the dividends and distribute them to shareholders, typically on a quarterly basis.
7. Price: The price of an ETF is determined by the value of the underlying assets. If the ETF tracks an index, its price moves in line with the index’s performance throughout the day.
8. Liquidity: Since ETFs are traded on exchanges, you can buy and sell them at any time during market hours, just like individual stocks.

Types of ETFs

ETFs can be categorised based on the assets they replicate:

• Equity ETFs by Regions: iShares Core MSCI World UCITS ETF (SWDA)
• Fixed Income ETFs: Xtrackers Eurozone Government Bond Yield Plus 1-3 UCITS ETF
• Sector ETFs: Xtrackers MSCI World Information Technology UCITS ETF
• Commodity ETFs: Global X Uranium UCITS ETF
• Currency ETFs: Invesco DB US Dollar Index Bullish Fund (UUP)
• Inverse ETFs: ProShares UltraPro Short QQQ (SQQQ)
• Leveraged ETFs: Direxion Daily Semiconductor Bull 3x Shares (SOXL)
• Country ETFs: Xtrackers MSCI Pakistan Swap UCITS ETF
• Strategy ETFs: Global X XYLD S&P 500 Covered Call ETF
• Thematic ETFs: Global X RNRG Renewable Energy Producers ETF

ETFs vs Mutual Funds

The main difference between ETFs and Mutual Funds lies in how they are traded. ETFs trade like stocks, meaning they can be bought and sold anytime the market is open. Mutual Funds are only priced and traded at the end of the day.

Other differences include:

Replication Methods of ETFs

There are two main types of ETF replication:

• Physical replication: The manager buys the underlying securities of the index to be replicated.
• Synthetic replication: The manager buys a swap contract with an investment bank, which pays the index’s return.

Many investors prefer physical replication due to actual ownership of the underlying assets. Synthetic replication introduces counterparty risk.

Within physical replication, methods include:

• Full replication: Buying all the underlying assets of the index.
• Optimised or sampling replication: Buying a representative selection of the total index portfolio to save operational costs.

ETFs can provide exposure to various markets, regions, sectors, and strategies. Examples include:

• S&P 500 ETFs: SPDR S&P 500 ETF (SPY)
• Thematic ETFs: Lithium & Battery Tech ETF (LIT), Cannabis ETF (POTX)
• Commodity ETFs: Global X Uranium UCITS ETF, Xtrackers IE Physical Silver EUR Hedged ETC

How to Invest in ETFs?

Understanding ETF concepts and how to acquire them is crucial. Creating an ETF portfolio depends on your investor profile and needs.

Investing in ETFs requires careful consideration of various factors to align with your investment goals and risk tolerance. Here are the key steps and considerations:

1. Understand Your Investment Goals and Risk Tolerance:
   • Determine what you aim to achieve with your investment. Are you looking for long-term growth, income, or short-term gains?
   • Assess your risk tolerance. ETFs can vary in risk levels based on their underlying assets and strategies.
2. Choose the Right Type of ETF:
   • Equity ETFs: For stock exposure, consider regional, sector, or thematic ETFs.
   • Fixed Income ETFs: For bonds and other debt securities.
   • Commodity ETFs: For investments in physical commodities like gold or oil.
   • Currency ETFs: For exposure to foreign currencies.
   • Inverse and Leveraged ETFs: For advanced strategies, including betting against the market or magnifying gains and losses.
3. Research and Compare ETFs:
   • Look at the ETF’s underlying index and its historical performance.
   • Consider the ETF’s expense ratio, as lower fees can enhance your returns over time.
   • Review the ETF’s liquidity and bid-ask spread to ensure you can buy and sell easily.
4. Consider the Tax Implications:
   • In the UK, ETFs are taxed like stocks, which means you’ll pay capital gains tax when you sell at a profit. Unlike investment funds, ETFs do not benefit from tax-free transfers between funds.
5. Select a Reputable Broker:
   • Choose a broker with low commission fees and a user-friendly platform.
   • Ensure the broker offers a wide range of ETFs and provides tools for research and analysis.
6. Build a Diversified Portfolio:
   • Spread your investments across different ETFs to reduce risk.
   • Balance your portfolio with a mix of asset classes and regions to mitigate the impact of market volatility.
7. Monitor Your Investments:
   • Regularly review your ETF holdings to ensure they align with your investment goals.
   • Stay informed about market trends and economic factors that could affect your ETFs.

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Why invest in ETFs?

Investing in ETFs offers several benefits that can appeal to a wide range of investors. Here are some of the key reasons why people choose to invest in ETFs:

Do ETFs provide diversification?

Yes, ETFs can provide diversification, and in many cases, they are designed specifically to offer broad market exposure to help investors achieve a diversified portfolio. Here’s how ETFs contribute to diversification:

Diversified Holdings:

• Many ETFs track indices that include a wide variety of securities (stocks, bonds, commodities, etc.), which can spread risk across multiple assets. For example, an FTSE 100 ETF gives exposure to 100 large UK companies, providing immediate diversification within the UK equity market.

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Asset Class Diversification:

• ETFs can be designed to track different asset classes, such as stocks, bonds, real estate, or commodities. This allows investors to diversify across different types of investments, helping to manage risk by not concentrating investments in a single asset class.

Sector and Industry Diversification:

• There are ETFs that track specific sectors (e.g., technology, healthcare, financials) or industries (e.g., energy, consumer goods). This can help an investor gain exposure to multiple companies within that sector or industry, providing diversification within that theme.

Geographic Diversification:

• Global or international ETFs provide exposure to foreign markets, regions, or countries. For example, Emerging Market ETFs or Global Equity ETFs allow investors to diversify outside of their home country’s market.

Cost-effective Diversification:

• Investing in an ETF that tracks a broad market index (like the FTSE 100 or a total market index) allows investors to achieve instant diversification at a relatively low cost, without the need to purchase individual securities.

However, it's important to note that while ETFs can offer diversification, the level of diversification depends on the specific ETF. For instance, a sector-specific ETF (e.g., one that focuses on technology) will provide diversification within that sector but may not be as diversified as a broader market ETF. Always be sure to understand the focus and holdings of the ETF you're investing in to assess how much diversification it truly offers.

Best Brokers for ETFs

ETFs are primarily traded through brokerage platforms, and finding one with low commissions is crucial, as buy-sell commissions can sometimes be high. Therefore, it’s important to analyse which is the cheapest broker to buy ETFs. For UK users, here are some of the best ETF platforms that are worth considering based on their reviews:

• Our Trading 212 review highlights its commission-free trading structure, making it an attractive option for cost-conscious investors looking for a wide range of ETFs with no added fees.
• According to Hargreaves Lansdown review, this well-established platform offers access to a broad selection of ETFs, combining competitive pricing with excellent customer service.
• Our eToro review praises the platform for its easy-to-use interface and commission-free ETF trading, ideal for both beginners and experienced traders who prefer simplicity.
• As per Interactive Brokers review, this platform is perfect for frequent traders or those seeking advanced features, offering low-cost ETF trading and a vast selection of global ETFs.

By reviewing these platforms, UK investors can select the one that best fits their needs, ensuring low fees and access to a wide range of ETFs.

FAQ

What are the origins of ETFs?

In 1992, Nate Most proposed creating an instrument that was cheaper, more efficient, and easier to buy and sell than indexed investment funds. Despite initial rejection from Vanguard's founder, John Bogle, Most successfully developed the first ETF, the SPDR S&P 500 ETF (SPY), with State Street in 1993.

Initially, all ETFs were passively managed, following an index. Recently, a new generation of actively managed ETFs has emerged, managed discretionarily by managers but retaining the benefits of the ETF structure, such as transparency and efficiency in operational and tax costs.

Is an ETF better than a stock?

An ETF can be considered better than a stock for diversification, as it allows you to invest in a collection of assets rather than a single company. Unlike stocks, which carry the risk of a single company’s performance, ETFs spread risk across multiple securities. However, for investors seeking high growth potential, individual stocks may offer greater returns, but with higher risk.

How do ETFs make you money?

ETFs make you money in two main ways:

1. Capital Appreciation: If the value of the underlying assets (like stocks or bonds) within the ETF increases, the price of the ETF rises, allowing you to sell it for a profit.
2. Dividends: Some ETFs pay dividends from the underlying stocks or bonds they hold. These dividends are distributed to ETF investors, providing a regular income stream.

In both cases, your returns depend on the performance of the assets within the ETF.