MoneyMagpie

Nov 17

Exchange-traded funds: a step-by-step guide

Reading Time: 5 mins

Exchange-Traded Funds (ETFs) provide a cheap, easy, and relatively reliable way to invest in the stock market. (Well, as reliable as possible – remember, any investment means you could lose money as well as make it).

They’re easy to buy and sell, with typically lower transaction and account fees than managed funds.

So, what are ETFs? How do they work – and why are they cheaper than other investments?

This guide covers everything you need to know – including a step-by-step guide on how to invest in them.

What are they?

ETFs mimic index-tracking funds in terms of how they work. They track selected parts of the stock market and your investment goes up or down depending on the performance of the ETF selection.

You can track commodities, markets like the FTSE 100, or even the performance of entire countries or market types. For example, you might want to track leading countries or take a little more risk – for more reward potential – by tracking ‘emerging’ market countries.

The passive investment nature of ETFs make them really cheap to invest in. A computer tracks the market – there’s no fund manager actively moving money around.

The big difference between ETFs and index-tracker funds

ETFs are companies in their own right. That means they’re traded like individual shares – so you need to go through either a stockbroker or online stockbroking platform to invest in them. (We’ll explain how to do that below!).

They don’t make any products like other companies you can buy shares in, like BT or Tesco. Instead, they make money investing in other shares.
Instead of investing in individual companies, an ETF buys shares across the selected market. This spreads the risk, as gains and losses average out. For example, a precious metal ETF would buy shares from gold, silver, and other mining companies.

If all those companies do well, the ETF value goes up, too. That’s because the individual shares held by the ETF company, in these mining companies, have all done well. If they all do badly, the ETF value goes down.

Usually, however, some go up and some go down. Over time, this (typically) means an overall increase in value.

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Why are ETFs a good investment?

The inexpensive ongoing costs of investing in ETFs make them ideal compared to managed funds.

High-cost funds may have a better track record for investors (but not always, and that’s not guaranteed) – but you have to pay the fees whether it’s been a good or bad year. So, if your portfolio loses money, you’re still paying a lot to fund managers. Even in good years, the percentage-based commission fees will eat into your profits.

An ETF investment has a much lower fee – meaning you get to keep more of your profits AND won’t be hit with huge fees even in low-performance years.
The simplicity of ETFs make them ideal for new investors, too. The funds invest into a stock market index, commodity, country, or market type directly: there are no complex layers to the investments.

Prices update every 15 seconds, too, so it’s easy to keep a real-time view of investments and help you determine the best time to buy or sell an ETF fund. Traditional fund investments, on the other hand, only update once a day.

How do they work?

ETFs are like a bag into which you can put your choice of simple investments. This ‘bag’ is a company in its own right that is traded on the stock market. Here are a few common questions asked about ETFs:

Is there a minimum amount to invest? Not really. You only have to buy one share to be involved in the fund, but obviously the shares differ in price.

Is there a minimum amount of time to invest? No, they’re very flexible. You can leave your investment in for as long or as short a time as you like.

Are the online brokers discretionary (i.e. do they give you advice on what to buy?) No, they only do what you want (i.e. they don’t give offer advice and then charge for their expertise). This is why their service is cheaper. You read up about funds) and just tell them online to go get ’em!

Do you need any specific information about them before you can invest? You need the code for the ETF that you want to invest in, which can be found on the search function of the broker’s site that you’re using. The main investment companies that offer ETFs are iShares, tracking stock market indices, and Wisdom Tree ETF Securities specialising in commodities ETFs.

Which online broker should I use?

The most popular online broker platforms include:

Research all of them before setting up an account. Some charge higher one-off fees while others have a flat-fee that suits high-volume traders (people who make more than a couple of transactions each month).

Check the funds available, too. Interactive Investor, for example, offers a wide range of fund options. Others, like Vanguard, only invest in their own highly-selected funds.

How do I set up my ETF?

First, you’ll need to set up an account with a broker. It’s free to register with them and you don’t have to buy anything immediately once you have your account. You can join now and wait for months before you invest in anything.

To open an account, you’ll need to provide certain information and may need to send proof of identity. You’ll need to show that you’re:

  • Over 18
  • A UK resident
  • A British national

And provide details such as:

  • Your address for the last 3 years
  • Your National Insurance number
  • Your debit card information.

When you’ve registered for an account, it’s easy to look at the ETF information on the site. That’ll help you understand which ones are performing well or have a positive historical performance. Previous performance doesn’t mean it’ll do well in the future – but can offer a guideline for new investors if the track record shows an overall positive trend.

When you’ve found an ETF – or several – that you’d like to invest in, you’ll need to transfer money to your online account. When you’ve got funds in your account, you can purchase shares in the ETF(s) you’ve had your eye on.

Don’t forget to protect it from tax – if you can

You can save a lot of money over time by using ISAs – tax-saving wrappers – to protect your money from tax. ISAs are not products in themselves, they’re like wrappers into which you put an investment and that wrapper stops you having to pay tax on anything you make.

With a Cash ISA, you set up a savings account (with a building society or bank) but when you get your interest, the government won’t take tax out of it.

With shares ISAs, if your investment grows, you won’t be taxed on that growth. We all have an ISA allowance each tax year (April 6th Year One to April 5th Year Two), which is essentially a limit on how much money you can contribute to your ISA in any single tax year.

You can have a cash ISA and an equities ISA, but your personal tax-free savings allowance of £20,000 each year is split between them. So, you could put the full £20,000 into your stocks and shares ISA but not put anything into your cash ISA, or split the allowance between the two.

How do I track the progress of my ETF?

You can follow them in the mainstream financial press such as the Financial Times, or you can log into your online broker account to track the live status of your ETFs at any time. Note: Jasmine has invested in a FTSE 100 ETF.

Click here to check out our selection of free eBooks and brochures for more useful information.

WHAT DO YOU THINK?

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Ravindra Gokhale
Ravindra Gokhale
9 years ago

I want to invest in ETF. Can you plz recommend some? I mean what are the popular choices?
Many thanks

Andrew
Andrew
9 years ago

By the cheapest, I mean in terms of annual management charges in particular…

Andrew
Andrew
9 years ago

Thanks for your new book and website, which have opened my eyes to long term, low cost investing.

Just a query. I’m not sure that Hargreaves Lansdown is the cheapest place to go for a self select ISA wrapper if it is to be mainly filled with ETFs. Will iii do the job more cheaply?

chika
chika
10 years ago

Hi, is it possible to invest in ETF now, then wrap it in an ISA in the next tax year as i have already reached my ISA limit this year.

Paul Prowse
Paul Prowse
10 years ago
Reply to  chika

Hi Chika, Not as such. You can’t turn a non-ISA wrapped ETF into a wrapped ISA ETF. What you could do is: 1) Simply wait until the next tax year to invest in an ETF that is tax free through your ISA allowance 2) Invest in an ETF now (bear in mind it won’t be protected from tax) then cash it in during the next tax year. You would then be able to take the proceeds of that ETF, and invest it in a new ETF (which, as it’s a new tax year, could now be wrapped in an ISA).… Read more »

John
John
10 years ago

OK Guys,
I am up for ETF, Q is how to transfer/get out of my existing ISA accounts if they wont trade ETFs i.e. can I (& how) transfer from one ISA account with a Company i.e. FundsNetwork to one that accepts ETF trades ?

Thanks

John

Jasmine
Admin
10 years ago
Reply to  John

Sorry to take so long to reply – yes you can John. You can move your money from one Isa account to another. Just get the company you want to move to to contact the original company. It can take a while but it’s up to the new company to do the moving for you.

James Cook
James Cook
10 years ago

Rob, that has to be the dumbest question I have heard for quite a while! Any investment in shares carries the risk of losing money. If you don’t understand that, keep your money in the bank.

Tim
Tim
10 years ago

Having read your book and now online pages, I’ve finanally decided to take the plunge and invest in a ETF. I’m going to wrap the investment in an ISA and want to know – is it best investing in larger one-off lump sums or can I invest it with smaller monthly payments?

Jasmine
Admin
10 years ago
Reply to  Tim

Well I tend to buy in a lump (like you, I try to get it wrapped in an ISA too). The reason is that every time you trade you have to pay so it’s cheaper to invest in one go if that’s possible. Good idea to go for an ETF. I’m going to put my ISA money in one this tax year too.

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