What is an ETF?

It is always important to diversify your portfolio to minimise your exposure to risk. This is why many investors prefer investing in an Exchange Traded Fund (ETF). Below we explain what this investment vehicle does and how you can use it to benefit your portfolio.

An ETF is an investment designed to track the performance of a particular market segment or theme. For example, suppose you intend to invest in a range of up-and-coming pharmaceutical companies. Instead of buying into shares and bonds within this sector directly, you can buy into an ETF which already holds these assets.

As a result, if this sector tends to perform well, the ETF will rise in value. Likewise, if the sector starts to perform adversely, the value of your ETF will decline.

Like a mutual fund, an ETF is financed by pooling money together from like-minded investors. It is managed by a fund manager who then buys and sells its assets to keep in line with its investment objectives. What makes it different, however, is that an ETF is traded on a stock exchange such as the London Stock Exchange (LSE) or the New York Stock Exchange (NYSE).  

Most ETFs are generally passively managed. Therefore, the underlying assets change less frequently than actively managed funds. This set-up makes it easier for the ETF to track its performance against its desired outcome, rather than having a fund manager who will attempt to outperform an index.

While an ETF may seem the same as a mutual investment fund like a unit trust or an Open-Ended Investment Company (OEIC), there is one fundamental difference. As stated, ETFs are traded on a stock exchange, which means investors can buy them at varying prices throughout a trading day. The prices of mutual investment funds, on the other hand, are determined at the end of each trading day instead.

In addition, when you wish to withdraw your funds, the process for each investment operates differently. An ETF will sell your share to someone else on the stock exchange looking for your investment, which can take place instantly. An index fund will process its sell orders in bulk, meaning you will often get access to your funds later than an ETF.

There are various ETFs which track different indices or themes. Below are some of the most common ETFs available. 

An index ETF aims to provide its investors with similar returns to those found on its tracked stock exchange or segment of the market. For example, if your index fund tracks the FTSE 100, you can expect your returns to mirror this market’s performance.

This is done through an index ETF’s set-up, which looks to buying a small percentage, or a representative sample, of the assets on this exchange. So, an ETF tracking the FTSE 100 will have proportionate shares in all 100 companies.

Unlike an ETF which is focused on shares, a bond ETF will provide its investors with more certainty with their returns. Providing none of the firms issuing their bonds default on their payments, each bond will pay a fixed rate of interest so investors can have more certainty about their return.

What differentiates a bond ETF from a normal bond of fixed savings account is that the interest carries on indefinitely until the investor withdraws their funds. This is because once a bond comes to maturity it is replaced with new assets.

A commodity ETF will allow you to trade a host of different commodities such as gold, silver and oil. In addition to precious metals, it can also track agricultural products and energy resources.

Often, investors are not actually purchasing the commodity itself in this type of ETF, but instead a set of contracts associated with that particular commodity. For example, a gold-backed ETF will not own the gold itself but rather a set of assets such as gold mines or transportation vehicles.

A currency ETF will track the value of a single currency, such as the pound or dollar, or a basket of currencies linked to a particular theme. For example, a currency ETF tracking the currencies of established markets could track the dollar, euro and pound.

The performance of this type of ETF will be influenced by macroeconomic factors, such as interest rate hikes and political movements, which have a direct effect on exchange rates.

These types of ETFs will track the performance of eco-friendly projects. For example, a sustainable ETF could track the performance of companies producing electric cars or solar paneling.

Mainly, ETFs offer diversity and distribute your risks more evenly. If you invested in one company instead of a host of similar companies, your investment would carry much more risk. That one company could be caught up in a scandal, badly managed, or simply produce disappointing dividend returns, meaning your entire investment pot could fall with it. An ETF, however, will weight the money across a number of investments accordingly.

Moreover, one of the main advantages of an ETF is that the fees involved are generally lower than investing directly. Purchasing all the shares and bonds that you find in an ETF will likely come with transaction costs which are much higher. An ETF, on the other hand, will provide a single transaction cost for your investment.  

Since ETFs behave like equities on a securities exchange, there is the possibility that investors can make a loss on their investment. Those who prefer a level of certainty on their returns over time could consider a savings account instead. Our charts display the current best rates on the market for savings and ISA accounts.

While the fees are generally lower than paying for each stock individually, some companies which create these ETFs charge commission or fees to the investor for investing in their funds. If you plan on adding money to your savings rather than a one-off lump sum, you may pay more in commissions than you would save on other fees.

You can purchase ETFs from many different investment platforms. Two of our preferred commercial partners, interactive investor and eToro, offer different types of ETFs.