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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.
What is an ETF?
An exchange traded fund (ETF) can be thought of like a basket that’s filled up with other types of investment or “assets”.
Equally, you could have a “European sustainable energy ETF”, filled up with European companies which focus on renewable energy.
Compare platforms to buy ETFs
ETFs trade just like stocks. Here are some of the UK’s leading platforms that will let you buy ETFs.
The advantages of ETFs
- 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 and so it isn’t very “liquid”. Cash is considered to be the most liquid asset. Anyway, ETFs trade on an exchange just like stocks. That means they have daily pricing and can be bought and sold moment to moment for a given price.
- Diversification. Diversification is the investing equivalent of “don’t put all your eggs in one basket”. Diversification is generally good, and like we mentioned above, ETFs give investors easy access to a broad (or diverse) range of assets. By buying just one ETF, an investor can get access to 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 gain access to 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.
The disadvantages of ETFs
- Passive. ETFs only replicate the returns from a specific asset class. If that asset class falls, the ETF will fall with it. This is in contrast to 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.
The different types of ETF
There are loads of ETFs out there, and the market is growing in size and sophistication all the time.
In general, ETFs fall into two main categories – physical and synthetic replication… stick with me here.
“Physical” replication is when the ETF holds the underlying asset. In the case of an S&P 500 ETF, this means that the ETF would hold all the underlying stocks in the index.
“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. 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.
Most of these indices will be market-cap weighted – i.e. 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, multi-national 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.
There is a vast range of sector ETFs from which to choose. These might include 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 weight 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 sounds like a contradiction, but they are a relatively recent innovation whereby 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.
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.
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 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.
The difference between ETFs and index funds
In practice, stock market-based ETFs will look similar to normal passive funds. There are two key differences: the way they’re traded (bought and sold) and fees.
As with all collective funds, an ETF pools the capital from a group of investors to invest in a specific range of stocks. The key difference is that ETFs can be traded at any point during the trading day. Investors will get the price they’re shown at the point they sell. For mutual funds, investors can sell at any time, but orders are only processed once a day. That means the market can move before an investor gets their money. This can cause problems at times of significant market volatility.
Equally, there tends to be more choice with ETFs. In general, index funds will only track the main equity indices rather than commodities, bond indices and other areas. Costs may also be lower for ETFs.
How to pick an ETF
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 on 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 brand. 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, 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 is sticking close to the index or asset that they claim to be tracking.
Possible ETF strategies
How investors use ETFs will be highly individual and depend on their risk appetite and financial goals. Some may use an MSCI World tracker as a way to get started in investing until they have built up confidence. They can 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.
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 by themselves.
Then there will be those who are 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 can be a good way to practice.
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.
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