A beginner’s guide to exchange traded funds (ETFs)

Here's the lowdown on exchange traded funds – the benefits, the risks and how to get started.

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Exchange traded funds (ETFs) are a type of fund listed on a stock exchange. These are pretty good investments for beginners, as they give you lots of diversification in one quick investment. This is because they’re collections of investments, including different types of investment across different sectors and countries.

ETFs can be a great way to get exposure to a broad range of different investments without the added faff of dealing with each investment yourself, especially if you’re not confident creating a portfolio on your own. Find out more about ETFs and how they work, as well as how you can get started and some pros and cons of ETFs.

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What is an ETF?

An exchange traded fund (ETF) can be thought of as a basket filled up with lots of investment types (known as assets). You can invest in an ETF with just one investment, getting you exposure to everything in the fund in one go, which is great for beginners, those investing small amounts or those that don’t want to create their own investment portfolio.

ETFs are often themed, with a connecting factor for the stocks or investments included. For example, you could have a “US stocks ETF”, a basket filled with the stocks of individual US companies like Apple, Amazon and Tesla.

Equally, you could have a “European sustainable energy ETF”, filled up with European companies which focus on renewable energy.

The most popular ETFs tend to track major stock market indices (like the S&P 500 or the FTSE 100).

How do ETFs work?

Exchange traded funds (ETFs) are quite easy to wrap your head around. An ETF investment is a single security containing a bundle of stocks and shares. So, when you invest in an ETF, you get to own a piece of each and every asset in the fund.

The 2 main ways for ETFs to be structured are:

  • Market weighting. The most common structure is for an ETF to be arranged by market capitalisation. In practice, market-cap weighting means that more of your investment goes towards the bigger holdings at the top. For example, if you invest in a popular S&P 500 index ETF, roughly 27% of your investment goes to the top 10 stocks.
  • Equal weighting. Less common, an equal weighting means that the same proportion of your investment goes to each holding in the ETF. So, if you were to invest in an equal-weight ETF of the FTSE 100 index, 1% of your investment would go to each share.

Most ETFs work the same way as index funds, but ETFs are called “exchange traded” because you can buy them on multiple stock exchanges (unlike index funds). This makes trading ETFs accessible for most investors because you can buy the same ETF on different platforms, just like stocks.

Types of ETF

There are loads of ETFs out there, and the market is growing in size and sophistication all the time. Some examples include:

  • Major index ETFs
  • Sector ETFs
  • Style or factor-based ETFs
  • Actively managed ETFs
  • Commodity ETFs
  • Currency ETFs
  • Bond ETFs
  • Environmental, social and governance (ESG) ETFs

ETFs can be in more than one of the categories above. For example, you could get an actively managed sector ETF that considers ESG factors. We’ve explained each category in more detail below.

What's physical or synthetic replication?

In general, ETFs fall into 2 main categories based on replication – physical and synthetic.

Physical replication

Physical replication is when the ETF holds the underlying asset. In the case of an S&P 500 ETF, the ETF would hold all the underlying stocks in the index.

Synthetic replication

Synthetic replication is when the ETF issuer replicates the index by taking out a derivative or swap with an investment bank. The investment bank agrees to provide the return of the index to the investor.

Is physical replication better than synthetic replication?

There are pros and cons to each type of ETF – in the US, physical replication is more popular because of some regulatory constraints, while synthetic replication is used more widely in Europe. Issuers of synthetic funds say they tend to track the underlying asset more closely, while critics suggest that synthetic replication introduces more counterparty risk.

Major index ETFs

The most popular and well-established ETFs track the major stock market indices around the globe.

The world’s largest ETF is the SPDR S&P 500 ETF (SPY), which currently holds around $320 billion in assets (about £267 billion).

Most of these indices will be market-cap weighted, which means they have the highest weighting in the largest stocks in any index. Different sectors dominate different stock markets. The UK’s FTSE 100, for example, is skewed to the large oil and gas companies, multinational banks and pharmaceutical companies, while the S&P 500 is focused on technology, including behemoths such as Apple, Microsoft and Amazon.

For investors, these ETFs provide diversified exposure to key stock markets. However, it is worth checking the type of exposure. The FTSE 100 won’t suit fans of high-growth technology stocks, for example. These investors may prefer the S&P 500.

FTSE 100 vs S&P 500

Sector ETFs

Sector ETFs are exactly what they sound like: they’re groups of investments linked to a specific sector. There is a vast range of sector ETFs to choose between, including technology, agriculture, energy and artificial intelligence. These allow investors to take advantage of exciting new areas of the market, which may not be included in their “core” investment strategy.

Style or factor-based ETFs

These have become increasingly popular in recent years. Instead of weighting by the size of the company, these ETFs will be weighted by different styles or factors. That might be high revenues, or share price momentum, or dividend yield. There will also be ETFs that track “value” or “growth” indices.

Actively managed ETFs

Actively managed ETFs are a relatively recent innovation where portfolio managers are more involved in picking companies for the portfolio and changing the holdings within the fund. These won’t be as cheap as conventional ETFs but aim to be cheaper than a fully active fund.

Commodity ETFs

These will track the price of individual commodities or a basket of commodities. This might be gold, oil, wheat or, more broadly, precious metals or agricultural commodities. These will either be physically backed – where the ETF will hold the commodity – or may be based on futures pricing.
Learn more about commodity ETFs

Currency ETFs

Currency ETFs will track the relative value of a currency or a basket of currencies. These may be “Bullish Dollar” or “Ultrashort Yen”. It is an alternative to placing individual currency trades and can be a useful way to hedge against major political events, such as a US election or Brexit.

Bond ETFs

Bond ETFs will be based on the major bond indices and are likely to focus on specific areas of the bond markets, such as global government bonds, investment-grade corporate bonds or high-yield (“junk”) bonds. One problem with size-weighted bond indices is that they tend to give the highest weighting to the most indebted companies. However, ETF providers have increasingly explored alternatively-weighted indices in response to this problem.

Environmental, social and governance (ESG) ETFs

ETFs that bring in environmental, social and governance (ESG) criteria have been among the most popular areas recently. These ETFs will either exclude individual sectors, such as tobacco, armaments or pornography, or they will tilt the portfolio towards companies with the highest ESG scores based on the assessment of ratings providers such as Morningstar. There will also be ETFs dedicated to specific areas, including climate change or the energy transition.

How to pick ETFs

Many of the major ETFs will look very similar. An S&P 500 ETF, for example, is likely to charge 0.1% or lower as its annual management fee. As such, there doesn’t tend to be a lot of differentiation in price. With more complex ETFs, including commodity ETFs, there can be more price variation, so it is worth seeing how the ETFs compare.

Investors may be reassured by the brand of the ETF. There are the major global providers – iShares is the largest, followed by Vanguard, State Street, Invesco and Charles Schwab – who sit alongside more specialist providers, such as ETF Securities, Amundi and Wisdom Tree.

Investors may also want to check how the ETF replicates the index – whether it is synthetic or physical replication – and also how well they do it. It is important that an ETF provider sticks close to the index or asset that they claim to be tracking.

Where to buy ETFs

There are loads of share dealing accounts that let you invest in ETFs. However, some platforms are cheaper than others. And certain online brokerages give you a wider choice of ETF investments to choose from.

Although you can buy ETFs on most platforms, it’s worth double-checking that your share dealing account lets you buy the particular ETF investment you want and that you’re not charged high fees or commissions.

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All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.

Are ETFs good for beginners?

Yes! ETFs are often considered one of the best investments for beginners. They’re useful for beginner investors because many ETF investments are cheap, diverse and simple to understand. You can use a broad ETF to invest in an index that tracks the top stocks and shares in a particular country or the whole global market.

You can also use an ETF investment to invest in a whole sector, which can be less risky than picking individual stocks. Because ETFs let you invest more broadly with a single investment, you get some automatic diversity. However, not all ETF investments are good for beginners. Certain ETFs invest in more complex areas. So it’s often best for beginners to use an ETF that tracks a major stock market index – these are usually the cheapest and easiest to grasp.

ETF strategies

How you use ETFs in your portfolio will be highly individual and depend on your risk appetite and financial goals. Some investors use an MSCI World tracker as a way to get started in investing until they have built up confidence. They might then add selected exposure to other markets – the US, UK or emerging markets – as they put more of their savings to work in the market.

If you’re thinking of investing in ETFs as a beginner investor to get good diversification, you could invest most of your money into ETFs, then try to “beat” the ETF performance with your own DIY portfolio. Once you get the hang of individual investments, you can reduce your ETF holding and increase your portfolio.

For those looking to blend ETFs, the key is to find a diversified group of ETFs that won’t all go down at once if markets fall. This means finding assets that move independently of each other. Government bonds and stock markets, for example, tend to move in opposite directions.

Commodities such as gold can add defensiveness to a portfolio, while an artificial intelligence ETF would add some spice. Online brokers will often offer suggested asset allocation for a given level of risk – cautious, aggressive and so on.

Many of the major ETF providers will offer ready-made portfolios of ETFs based on age and life stage. In general, these will vary the level of stock market exposure to take account of risk appetite. This can be an easy option for those who don’t want to manage a portfolio of ETFs alone.

Then there will be those looking to ETFs for trading strategies. ETFs lend themselves to regular trading because of their liquidity and choice. While this is an option for sophisticated investors, it can offer a gateway to more sophisticated derivatives trading. With ETFs, investors cannot lose more than they put in, so it can be a good way to practise.

Do ETFs charge fees?

Yes, most ETFs charge an OCF (ongoing charge). This will be shown as a percentage amount, and your fee will be based on how much of that ETF you own. Sometimes the fee will be referred to as TER (total expense ratio). It depends on the fund.

On top of this, your brokerage might charge a one-off commission for buying an ETF and perhaps a separate ongoing fee to hold ETFs in your portfolio. Some brokerages are better than others when it comes to buying and holding ETFs. For some ETFs, you may also have to pay an FX (foreign exchange) fee when you invest.

Pros and cons of ETFs

Pros

  • They’re cheap. ETFs are generally pretty cheap (because there are fewer costs associated with just loading up a basket of investments than actively trying to pick the best ones).
  • Liquidity. Liquidity is just a fancy finance word for how quickly and easily something can be converted into cash. Quick example, a house isn’t that easy to sell, so it isn’t very “liquid”. Cash is considered to be the most liquid asset. ETFs trade on an exchange just like stocks, so they’re priced daily and can be bought and sold anytime the stock market is open.
  • Diversification. Diversification is the investing equivalent of “don’t put all your eggs in one basket”. Diversification is generally good, and as we mentioned above, ETFs give investors easy access to a broad (or diverse) range of assets. By buying just one ETF, an investor can access every stock in the FTSE All Share, for example, or the S&P 500. This means investors don’t have to pick individual shares and aren’t significantly exposed to weakness in an individual stock.
  • They’re easy. No one wants to take delivery of 1,000 barrels of oil or a series of gold bars with all the associated storage and insurance costs. ETFs offer a means to take exposure to certain asset classes in an easy and liquid way.
  • Choice. The ETF market has exploded in recent years. It is possible to access a vast range of asset classes and investment strategies in ETF form. This can help add spice and resilience to a portfolio.
  • Taxes. There are certain tax advantages to an ETF over holding individual shares. There is no tax to pay on capital gains built up within an ETF. Investors only pay capital gains on the difference between the price at which they buy and sell the ETF.

Cons

  • They’re passive. ETFs only replicate the returns from a specific asset class. If that asset class falls, the ETF will fall with it. This contrasts active investments, where a fund manager can move to cash or switch holdings.
  • Indexing. ETFs suffer from the same problems as all index funds in that they will invariably include some companies that investors would rather not have in their portfolios. It’s the nature of an investment like an ETF that you’ll be picking some losers as well as some winners. The major indices, such as the S&P 500 or FTSE 100, are skewed to the largest companies in the market, which may be different from the best and fastest-growing companies in a market.
  • Difficult asset classes. There are some asset classes where it is difficult to replicate the performance in an ETF. Areas such as private equity or property, for example, are tough to track. Equally, there is a danger with some bond ETFs that they give exposure to the most indebted companies as these have the largest weightings in bond indices.
  • Counterparty risk. Some ETFs come with some counterparty risk – the risk of the issuer going bust. This is a greater risk with “synthetic” ETFs, where there is an investment bank on the other side of the trade. That said, most ETFs have improved their risk management in recent years, bringing in more appropriate collateral in the event of default.

Bottom line

ETFs are a cheap and liquid way to access a range of investment markets. Investors can use them at the heart of their portfolio or to take exposure to niche markets. They are now a huge market, and their popularity is likely to continue.

Frequently asked questions

What does ETF stand for?

It stands for exchange traded fund.

What is ETF trading?

Trading ETFs simply means the buying and selling of exchange traded funds (ETFs).

What is an ETF portfolio?

This is an investment portfolio made up of a combination of various ETFs. So, instead of creating a portfolio with individual stocks and shares, an ETF portfolio can be more diversified and easier to manage.

Are ETFs tax-free?

No, unless you hold your ETFs in a stocks and shares ISA or a SIPP (self-invested personal pension), you’ll have to pay dividend or capital gains tax (CGT) on any profit you make.

Do ETFs increase volatility?

It depends. Typically, ETFs are less volatile than many other types of investments. However, this isn’t always the case. For example, if you invest in an ETF that tracks a specific area, your ETF will reflect the volatility of that sector or market.

Do ETFs compound?

Yes, they can. If you want to use an ETF that compounds automatically, you should pick an accumulation ETF. To do this, choose an ETF with the letters “Acc” at the end of the name. Or check the Key Information Document (KID). Accumulation means any income is rolled back into the fund, compounding automatically.

Which ETFs perform best?

It depends on the timeframe you’re looking at. Broad market ETFs have been very successful over long periods, for example – tracking the S&P 500 index. However, in recent years, tech stocks have performed so well that an ETF tracking the Nasdaq 100 would have been one of the best performers. It’s important to have a long-term view and pick an ETF investment that suits your goals.

We update our best ETFs page every month, so give it a look to learn more about the best-performing exchange traded funds

How is an ETF different from a stock?

A stock is a single investment in one company, whereas an ETF usually contains a whole basket of multiple stocks.

What’s a single-stock ETF?

This type of ETF is rarer and newer. These are only recommended for experienced investors because they’re more complex and are used for leverage or inverse trading on a single stock.

All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.

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