What is an ETF – and is it the best investment for you?

10 min Read Published: 05 Apr 2022

What is an ETF?What is an ETF?

An exchange-traded fund (ETF) is a type of investment that lets you invest in a number of different shares or bonds. They typically track a specific index, sector or basket of commodities, aiming to replicate them as closely as possible. They do this by holding the same underlying assets as the part of the market they are trying to replicate. In this respect, they work in much the same way as an index tracker fund. The key difference is that ETFs are traded on stock exchanges, meaning shares in individual ETFs can be bought and sold by investors. This means the price of the ETF will fluctuate throughout the day as it is traded.

ETF - key features

  • Good levels of diversification as they contain a large number of companies or bonds
  • Typically cheaper than index funds and other fund types and often require a lower minimum investment
  • Traded on a stock exchange and are, therefore, easily bought and sold
  • Can be passive or actively managed, although the majority are passive
  • As with any investment, their value can go up and down over time

How do ETFs work?

An ETF will generally replicate indices or specific parts of the market by physically holding the same assets. For example, if an ETF is aiming to track the S&P 500 index, it will hold all 500 companies that make up the index. It does this by working with an institution like an investment bank, which works on the ETF provider's behalf to buy the underlying assets of the part of the market they are looking to replicate. This is known as a "physical" ETF.

Another option is a "synthetic" ETF, which uses "swaps", which are an instrument that pays the same returns as the underlying investments the ETF is tracking. These types of ETFs are usually associated with commodities or foreign exchanges that don't allow foreign investment. This is because they allow replication in situations where buying the actual physical assets would be difficult or impossible.

Another type is active ETFs, which are run by managers who choose the assets included in the portfolio and the weightings to the individual holdings. Active ETFs generally have higher fees attached to them than their passive counterparts.

How to invest in ETFs

The two main ways to invest in an ETF is either through a general investment platform, such as Hargreaves Lansdown*, AJ Bell* or Interactive Investor* or with a trading platform like Freetrade*, Trading 212 or eToro. The choice between them will largely depend on what else you want to invest in within your wider investment portfolio, as well as weighing up the products and services they offer and the fees they charge. For a more detailed run down, read our article "What is the best way to invest in index funds or ETFs?"

Once you have chosen your platform, you can move on to working out which is the best ETF for you, or whether you want to invest in more than one. To do this you should consider:

  • Are you looking to target a specific area of the market? Are you looking for the broad diversification offered by one of the main indices, such as MSCI World, S&P 500 or FTSE100, or would you prefer to target a specific sector?
  • What level of risk can you tolerate? Does the ETF match your risk appetite? How does it work with other investments you have?
  • Are you looking to buy and hold or do you anticipate you will be trading more frequently? If it's the latter, you need to consider the trading fees charged by your platform.

Most platforms offer a search function, which allows you to screen the various ETFs on offer. There may also be independent research or recommendations, depending on the individual platform. If you are unsure about the best option, it is worth consulting with a financial adviser, who can work out your individual needs and also assess how an ETF could fit within your wider portfolio.

How much do ETFs cost?

One of the most appealing things about ETFs is the fact they are low cost. Indeed, the average fund charge for a passive ETF or index fund is around 0.15% - £150 per year for every £10,000 invested - compared with 0.67% for active funds. There are, however, other costs associated with investing in ETFs which should be factored in and we explain some of these below.

Platform charges

If you are investing through a general investment platform, you will normally either pay a percentage of the total amount you have invested per year, or you will pay a flat monthly fee. With a trading platform there is often no platform fee, but you may be charged for withdrawing your money or for currency conversion.

Trading charges

If you opt for a trading platform, you often won't have to pay anything for buying or selling ETFs as they make money from the "spread", which is the difference between the buy price and the sell price. This can work out to be cost-effective if you are planning to take an active approach to your portfolio, making frequent changes.

For general investment platforms, meanwhile, there will generally be trading charges for each transaction you undertake. For example, Hargreaves Lansdown charges £11.95 for each deal, although this is reduced if you make a certain number of transactions per month. To find out more, read our round up of the best and cheapest platforms.

Advantages of ETFs

  • Low cost compared with other investment types
  • An easy way to introduce diversification into your portfolio as you can include all of the companies in a particular index or sector
  • Readily available and easy to buy and sell as they are traded on stock exchanges
  • Can provide access to more esoteric assets that you may not be able to invest in directly

Disadvantages of ETFs

  • Depending on the platform you use, the trading costs involved in buying and selling ETFs can start to add up, especially if you make frequent changes
  • There is a risk, particularly with synthetic ETFs, of the financial institution facilitating the construction of the ETF going bust. Although this "counterparty risk" is small, it is something investors need to be aware of
  • The price of an ETF can fluctuate and the value of your investment can go down as well as up, as with other investments

Summary: Should you invest in ETFs?

ETFs have become an increasingly popular option among investors, who are drawn to them because of their low cost and the diversification they can provide. Indeed, many robo-advisers, such as Nutmeg and Wealthify*, primarily use ETFs and index funds to populate their risk-rated portfolios because of these characteristics.

Whether an ETF is right for you largely depends on which specific ETF you choose and how it fits in to your wider portfolio. By their nature, they take on the features of the part of the market they are representing and their price will move accordingly. There certainly isn't a one-size-fits-all with ETFs and it pays to do your homework - or get advice from a financial adviser - to see how you could successfully incorporate them into your portfolio.

 

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