Diversifying your investment portfolio can be costly. That is why ETFs, or exchange-traded funds, hold such appeal.
For the price of just one share, you can gain exposure to hundreds of different assets. That share is then easily tradable through your broker or investment platform account.
But what is an ETF? And how do they work? Read on to discover more about investing in exchange-traded funds.
» MORE: What is the stock market?
ETF meaning
An EFT is usually designed to track a specific segment of the financial market. This means it can contain anything from stocks and bonds to forex and commodities (such as oil or gold).
Like a mutual fund, ETFs pool together money from more than one investor in order to access a diversified range of assets.
What makes ETFs different from other types of funds is that shares in an exchange-traded fund can be bought and sold between investors on a stock exchange, hence the ‘exchange traded’ part of ETFs.
» MORE: How to buy shares
How do ETFs work?
An exchange-traded fund tends to represent a pre-established segment of the financial market, with the aim of tracking that segment’s price performance.
The ETF will do this by holding the assets that make up that market segment. This usually means the fund will physically buy these assets in order to create a replica of the segment in question.
For example, if you had an index ETF tracking the FTSE 100, the ETF would own shares in each of the 100 companies that constitute the Footsie.
Although most ETFs are passive, i.e. they track a pre-established segment of the market such as an index, active ETFs also exist. These would be exchange-traded funds where an investment manager has hand-selected the assets contained within the ETF.
» MORE: How does the FTSE 100 work?
How are ETFs created?
Before an ETF can be created, the ETF provider – which designs and manages the fund – will need to gain permission from both the stock exchange it wants to list on and the regulator that oversees the exchange. For example, to list on the London Stock Exchange (LSE), a provider would need permission from the LSE and the Financial Conduct Authority (FCA).
ETFs are then brought into existence through a process called the creation/redemption mechanism.
Creation process
When an ETF provider wants to create an ETF, it has to do so in coordination with an Authorised Participant (AP). This will normally be a large investing institution such as an investment bank, with enough buying power to purchase all the underlying assets that make up the market segment the ETF wants to track.
Once the AP has bought the shares, they will then sell these assets to the ETF provider in exchange for an equal value of shares in the ETF, based on the ETF’s net asset value (NAV).
Net asset value is the value of all the assets in an ETF, minus any liabilities, divided by the number of outstanding shares. This is calculated once a day.
The AP would then be able to sell these shares in the ETF on a stock exchange to both retail and institutional investors. This, therefore, creates the market for an ETF.
Redemption process
This is essentially the reverse of the creation process. An Authorised Participant would buy up a number of ETF shares on the stock exchange and then trade them back to the ETF provider.
In exchange, the AP would receive the underlying assets that comprise the ETF in the same amount as the net asset value of the ETF shares it had traded.
An important feature of the creation/redemption mechanism is keeping the market value of an ETF share, which rises and falls based on demand, in line with the net asset value of its underlying components.
Types of ETFs
Since an ETF is defined by the assets it tracks, there are a number of different types of exchange-traded funds. These include:
Index ETFs
The most common, and easiest to understand, type of ETF is an index ETF. This is a form of index fund.
An index ETF turns an index, which has no physical value, into something people can invest in. It does this by buying all, or a representative sample, of the assets that make up an index, in the same weighting as each asset is given in the index.
Often, index ETFs will be stock ETFs. For example, an S&P 500 ETF would contain all 500 companies that comprise the S&P 500 index.
Stock ETFs will pay dividends based on the collection of stocks within them, which can either be reinvested into the ETF or paid out to investors.
» MORE: What is an index?
Bond ETFs
It is possible to find bond ETFs covering every type of bond, from treasury bonds to corporate bonds and beyond.
An important difference between bonds and bond ETFs is that the former have a fixed maturity date, while the latter do not mature.
Bond ETFs maintain a constant maturity by being continuously replenished with new assets as some of the existing bonds mature.
They differ from stock ETFs, meanwhile, as they often pay out monthly interest to investors.
» MORE: What are bonds?
Commodity ETFs
Commodity exchange-traded funds can allow you exposure to a basket of different commodities through one product.
These ETFs will often track commodity indices. Each index, and therefore ETF, will give its own weighting to the various commodity sectors, including energy, industrial and precious metals, agriculture and livestock.
As well as ETFs covering a basket of commodities, you can invest in ETFs that track the price of just one commodity such as gold.
» MORE: How to invest in gold
Currency ETFs
A currency ETF will reflect either the value of a single currency, such as the US dollar or pound sterling, or the value of a thematically-linked basket of currencies such as emerging market currencies.
» MORE: How does forex trading work?
ETFs vs mutual funds
ETFs and mutual funds share a lot of similarities. Both are professionally managed products that pool together investors’ money to build a portfolio of financial assets.
However, their differences may mean one is better for your own personal investment strategy than another.
| Exchange-traded funds | Mutual funds | |
|---|---|---|
| Costs and fees | Subject to expense ratios – i.e. management and admin fees – and potentially commission fees per trade. These fees and costs are usually lower for ETFs than mutual funds, while ETFs can also be more tax efficient. | Subject to expense ratios and other costs associated with activity within the fund, such as buying or selling shares. |
ETF trading
To invest in ETFs, you first need to open an account with a broker or investment platform.
Once you have opened your account, you should then carefully research the type of exchange-traded fund you want to invest in.
Factors to consider would include the size of the ETF (i.e. the number of underlying assets in the fund), the type of assets themselves, and the costs associated with trading the ETF.
You would then be able to buy and sell shares in an ETF just as you would shares in a company.
» MORE: How to get started investing
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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