Exchange traded funds (ETFs) explained

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Exchange traded funds, more commonly referred to as ETFs, are funds that track an index or a group of securities. They were created as an investment tool, and are growing in popularity. ETFs offer many benefits for investors, one being that they provide the opportunity to diversify an existing investment portfolio. On this page, you’ll learn what ETFs are, how they work and the different types of ETFs available.

Key takeaways
  • Exchange traded funds operate similarly to mutual funds, but unlike mutual funds, ETFs can be purchased or sold on an exchange, just like stocks

  • With an ETF, you can own stocks across several industries, or your fund could be isolated to only one industry or sector

  • The price of an ETF can fluctuate throughout the day, due to an open market that allows buying and selling at any time of day

What is an exchange traded fund?

An exchange-traded fund is essentially a ‘basket of securities’ that trade on an exchange. ETFs replicate the return of an index which consists of securities including stocks, commodities and bonds. Because an ETF typically contains multiple securities, they can be a popular choice for diversification. Additionally, ETFs are traded on an open market that allows buying and selling at any time of day. Also, they tend to offer lower expense ratios and commissions than mutual funds, because ETFs are passive investment vehicles which do not rely on a fund manager selecting and trading securities.

ETFs are similar to index funds in that they track a stock market’s performance by looking at the way stocks are bought and sold. They’re also similar to mutual funds, where stocks or shares are only traded once per day after the market closes, although ETFs can be more cost-effective and liquid.

The following graph shows the amount of money, in trillions of dollars, invested in ETFs worldwide:


How do ETFs work?

An ETF aims to track the price performance of a pre-established area of the financial market by holding assets that make up that particular market segment. For example, you could have an ETF that tracked the FTSE 100 (so the ETF would own shares in each of the companies that comprise the FTSE 100) or an ETF that tracked the energy sector (so the ETF would include shares in companies operating in this sector).

The number of shares in an ETF can change due to the index it is tracking. The index itself can change, admitting shares of new companies or excluding shares of companies who went bankrupt or do not fit the index criteria anymore.

What are the different types of ETFs?

Investors can utilise different types of ETFs to generate returns and diversify their investment portfolio. The most common ETFs used by investors are the following:

  • Market ETFs – designed to track a particular stock index such as the FTSE 100, S&P 500 or Japan’s Nikkei index
  • Bond ETFs – provide an investor with exposure to all different kinds of bonds, such as government bonds and corporate bonds. Compared to stocks and corporate bonds, government bonds from countries with a high investment rating such as the UK can be a lower risk investment that’s good for diversifying a portfolio
  • Industry ETFs – if you have an interest in a particular sector, industry ETFs allow you to invest in specific industries, such as technology, banking or pharmaceuticals
  • Commodity ETFs – this type of ETF allows investment into different commodities, tracking the value of gold, crude oil or even corn
  • Currency ETFs – these are designed for investment in foreign currencies, such as dollars or euros
  • Inverse ETFs – inverse ETFs are used to earn gains from stock declines by a method known as ‘stock shorting’. Shorting is when an investor sells a stock that’s expected to decline in value and repurchases the same stock at a lower price

Pros and cons of ETFs

Advantages of ETFs

  • ETFs allow an investor to effortlessly diversify their portfolio, providing easy access to many stocks, commodities and bonds.
  • ETFs typically provide lower average costs than other funds
  • ETFs tend to be more liquid than mutual and index funds, meaning it’s easier to convert the fund into cash without affecting its market price
  • ETFs incur lower expense ratios and broker commissions when compared to mutual funds. Also, an individual investor might find it expensive to buy all of the stocks held within one ETF.

Disadvantages of ETFs

  • ETFs typically incur a total expense ratio (TER), so it’s important to compare ETF prices costs before you commit to buying an ETF.
  • Investing in an ETF carries the risk of potential money loss due to fluctuations in value. As with any investment, you should do your research and consider how comfortable you are with the associated risks involved.
  • While many ETFs offer diversification, this isn’t always the case, as some ETFs are narrowly focused on a particular sector of the market.

If you’re more risk-averse, you might want to consider growing your wealth by opening a savings account instead. Savings accounts, such as notice accounts, easy access savings or fixed rate bonds, offer competitive interest rates and can guarantee a return on your investment without the risks of investing.

Do I have to pay for an ETF?

Fees will vary depending on the fund you choose and other factors. In the UK, typically you’ll pay an annual account charge that is a percentage of your total fund value. You may also pay a fee for fund management if you use a company to help you manage your ETF.

How do I buy and sell ETFs?

You can buy and sell ETFs any time the stock market is open. All ETFs are traded according to their current market price, and you make ETF trades through online trading platforms or traditional broker-dealers.

If you’d prefer not to use a broker, you could use a ‘robo-advisor’ which can advise you on making ETF trades based on a digital mathematical algorithm that requires limited human intervention.

Stay safe with a savings account that has a guaranteed return

If you want to quickly and easily open a savings account that can help you grow your savings and provides a guaranteed return on your investment, register for a Raisin UK Account and apply for a fixed rate savings account today. Fixed rate bonds offer competitive interest rates that don’t change from the day you open the account until the end of your term.