What is an exchange-traded fund (ETF)?

Exchange-traded funds (ETFs) are an investment option that combines various asset classes like stocks and bonds. Understanding ETFs can be important for investors as they offer flexibility, diversification and cost-efficiency. In this article, we’re going to explore how ETFs work, their types, benefits and associated risks.

ETFs are a type of investment usually made up of different asset classes like stocks or bonds. You can buy and sell them throughout the day through a stock exchange while the markets are open.   

How ETFs work

There are different types of ETFs, so they all work slightly different depending on the type.  We talk about these a bit later. Some track an index like the S&P 500, and some will be actively managed, so the asset holdings can change frequently. 

ETFs have two different prices:

• Bid – the amount someone is willing to buy at
• Offer – the amount someone is willing to sell at 

The difference between them is known as the ‘bid/offer’ spread.

Passive vs active ETFs

Passive ETFs are a type of investment that tracks the performance of an underlying group of investments like the S&P 500 Index, which is the benchmark for the performance of the largest 500 companies in the US.

In actively managed ETFs, specialists select investments for the funds, with the aim to outperform the benchmark.

ETF vs actively managed non ETFs

All funds – whether they are ETFS or are not - are vehicles to enable investment in the financial markets.

Actively managed funds (non ETFs) can only be purchased at end of each trading day. They tend to have higher fees because of the higher costs associated with the more hands-on management of such funds. More specially, the fund manager of such as fund will be tasked with aiming to outperform the fund’s benchmark.

ETFs can also be actively managed however such funds are less common. Costs will still tend to be lower than actively managed non ETFs. Actively managed ETFs will also trade throughout the day so can be bought or sold throughout the day as long as the markets are open. Actively managed ETFs will aim to outperform the market and so their benchmark like their actively managed non ETF counterparts.

There are various types of ETFs which hold different types of investments, such as:

• Equity ETFs – If you go for a passive Equity ETF they'll track a stock market, such as the S&P 500 Index. These are a collection of company shares that you can buy and sell on a stock exchange. 
• Bond ETFs – Bond ETFs are a type of investment where the investor is indirectly lending money to the government or a company. Bond ETFs are a collection of these assets that are usually considered lower risk than equity ETFs.
• Commodity ETFs – Raw materials such as gold, silver and oil are examples of commodities. Commodity ETFs allow you to invest in these physical things without having to own and store them. 
• Sector and industry ETFs – These invest in specific sectors like energy, biotechnology, and chemicals. 

 

There are a few advantages to investing in ETFs:

• Low cost – Fees for ETFs tend to be lower overall. As we've mentioned, less active management from fund managers is required for passive ETFs.
• Easy trading – As you’re able to trade at any point in the day while the markets are open, ETFs can be a great option for flexibility. 
• Diversification – We’ve all heard ‘don’t put your eggs in one basket’ ETFs have a multitude of different assets within them, meaning you’re spreading the risk depending on your choices.
• Dividends – ETFs come with the potential of dividends. A dividend is a payment of the companies shares based on their profits paid out to shareholders for each share they hold. You can usually choose for your dividend to be paid out as cash, or to purchase you more shares.
• Tax efficiency - When it comes to tax, ETFs are treated the same way as most traditional investments, meaning you need to pay capital gains tax on any profit that you earn. Depending on the type of ISA, ETFs can also be held in a stocks and shares ISA - which allows you to invest in a tax-efficient way, protecting any profits from UK income and capital gains tax. Please check the conditions of the ISA for more information. Tax benefits are subject to change and are dependent on personal circumstances. 

 

The markets are the biggest risk when it comes to ETFs, like any investment the value can go down as well as up, and you could get back less than what you put in.

Liquidity risk can also impact ETFs. It’s the risk you might not be able to buy or sell quickly at a fair price. This will happen when there’s not enough buyers or sellers, or when the ETF itself is hard to trade. This is why the markets can be seen as volatile.

There are a couple different ways you can invest in ETFs, depending on your support needs and how hands on you want to be.

• DIY it! – you can open up a stocks and shares ISA with a bank or a financial services provider - like us! You can get right in and research ETFs and pick from a range of investment options. This will mean you need to manage your investments yourself and be very hands on. 
• Get someone to do it for you – you could hire a financial adviser or go through a broker to get yourself started with investing. If you’re not sure where to start or what you’re doing, then having a completely hands-off approach might be the way forward for you.