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The basics of exchange-traded funds: What are they? And should you invest in one

Karl 20th Mar 2024 No Comments

Reading Time: 6 minutes

Exchange-Traded Funds (ETFs) allow investors to gain exposure to a large number of assets at a relatively low cost. 

In this article we’re going to take a deep dive into the world of ETFs by explaining how they work while highlighting the advantages and risks. 

Keep on reading for all the details, or click on a link below to head straight to a specific section.

What is an ETF?

Introduced in 2001, an ETF is an investment vehicle that tracks the performance of an underlying group of investments. For example, an ETF might mirror the performance of a particular industry, commodity, or major stock market index.

Because of how they work, ETFs are an efficient way for investors to gain exposure to lots of different assets without the need to purchase individual shares, bonds or commodities. 

In addition, the potential diversification benefits offered by ETFs could be huge. 

As we’ve covered a number of times here at Money Magpie, every investor should seriously consider diversification when putting together a portfolio. That’s because diversification can go a long way in helping to mitigate risk. 

Most ETFs are physical.

It’s worth knowing that the majority of ETFs, unless they are synthetic, are physical. 

Physical ETFs invest directly in the assets they track. For instance, a FTSE 100 ETF mainly invests in companies that make up the FTSE 100 Index, while a gold ETF mainly invests in gold bullion. However, it’s crucial to recognise that when you invest in an ETF, you’re essentially buying a stake in the ETF itself and not in the underlying asset. 

Income or growth?

Similar to mutual funds, ETFs typically offer ‘distributing’ and ‘accumulating’ units. 

For distributing funds, dividend income is paid to investors at regular intervals, usually quarterly or annually. On the other hand, with accumulating funds, any income is automatically reinvested back into the fund, rather than being paid to the investor. For investors looking to potentially benefit from compound interest, an accumulating fund could be the way to go.

Types of ETFs

There are various types of ETFs which cater to all kinds of investors. From equity, sector-specific, to international, here’s an overview of some prominent types of ETFs:

Equity ETFs:

Equity funds track the performance of stock market indices, such as the FTSE 100 or FTSE All-Share Index.

So, if you buy a FTSE 100 ETF its value will move in parallel to the collective performance of the 100 constituents within the index.

Sector-Specific ETFs:

If you’re looking to gain exposure to a single sector, then a sector-specific ETF could be for you.

As its name suggests, sector-specific ETFs track the performance of specific industries. For example, if you buy a healthcare ETF then your investment will mirror the performance of a range of healthcare stocks.

Thematic ETFs:

Thematic ETFs target specific trends and evolving industries, such as renewable energy. Thematic ETFs could be ideal for investors looking to put their capital towards a particular cause or industry they believe in.

Thematic ETFs are particularly popular with investors looking to make investing decisions that align with their personal values. For example, they might invest in an ETF that tracks the performance of socially responsible industries.

Bond ETFs:

Bond ETFs, or ‘gilts’ as they’re known in the UK, track the movement of the bond market. For investors looking to complement their equity holdings, investing in bond ETFs may provide some balance to a portfolio.

Commodity ETFs:

Gold, silver, oil, natural gas, and wheat are all examples of commodities. While investors can invest directly in these individual commodities, buying a targeted ETF which tracks an underlying commodity index is probably the easiest way to gain exposure to commodities.

For example, if you’re seeking exposure to gold, then buying the precious metal directly will mean you’ll need to consider the costs of storage, insurance, and even transport. However, with an ETF that tracks the price of gold aall this can be  sidestepped. Other risks are anyway involved.

International ETFs:

For investors keen to explore opportunities away from the UK, an international, or global ETF, could be the answer.

International ETFs can track the performance of an overseas stock market or country-specific benchmark. International ETFs may also be used to describe ETFs that mirror the performance of emerging markets.

The advantages of ETFs

There’s no doubt that these investment funds have a number of advantages, so let’s explore some of them.

1. You don’t need expert knowledge.

If you want exposure to a wide range of sectors, industries, or stock market indices, then it’s difficult to think of an easier way to go about it than to buy an ETF.

And because ETFs are straightforward to buy and manage, you need to have a good understanding of the product and read the related documentation before investing, but you don’t need to be an investing expert to get an ETF portfolio off the ground.

2. They’re relatively cheap to buy.

Because ETFs are essentially readymade portfolios which don’t require active management, they’re considered a cheaper way to invest – especially when compared to buying individual stocks and shares or relying on a fund manager to do it for you.

In fact, passive investing is generally regarded to be cheaper than active investing, mostly because passive investors don’t make as many trades as their active counterparts.

3. ETFs can make diversification easy.

Any established investor will tell you that having a diversified portfolio can go a long way in helping to minimise risks.

Given that ETFs can cover a wide number of assets within a single product they’re an easy way for investors to mix up their portfolio.

4. You can hold an ETF in a tax-free wrapper.

Because they trade like shares, you can hold ETFs in a normal Stocks & Shares ISA. This means it’s easy to stash a tax-free wrapper around your ETF investments.

(Don’t forget, for the current 2023/24 tax year, you can put up to £20,000 into an ISA)

ETFs: The drawbacks and risks

There’s no perfect investment product, and ETFs are certainly no exception.

Let’s take a look at some of the drawbacks and risks involved when it comes to investing in ETFs.

1. ETFs aren’t ideal for active investors.

If you enjoy picking and choosing your own stocks and shares, then buying a prepackaged ETF is unlikely to appeal to you.

To put it another way, ETFs are essentially designed for passive investors who prefer a hands-off approach. While there’s nothing inherently wrong with active investing, if you enjoy meddling with your investments on a regular basis then an ETF is probably not for you.

2. ETFs can’t beat the market.

Pay for the services of a stock market professional and he or she will do their best to beat the market (for a fee, of course). However, because ETFs can only track the price of an underlying index, by definition, they cannot ‘beat’ the market.

So, if you’re an ambitious investor seeking above-average returns, you’ll probably want to give ETFs a miss.

3. The risk of falls.

Just like with any other type of investing, ETFs are subject to market fluctuations. For example, if you choose to invest an ETF that tracks a stock market index and the economy tumbles, then it’s likely the value of your ETF will fall.

On a similar note, if you invest in a bond ETF and interest rates rise, then this likely to have a negative impact on the value of your ETF given the relationship between the bond market and rising interest rates.

4. Concentration risk

If you buy a sector-specific ETF and that sector experiences a downturn, it’s probable you’ll see the value of your investment decline.

This risk can be minimised, however, by gaining exposure to more than one sector. You may be able to achieve this by buying a number of different ETFs, or a single ETF that has exposure to multiple sectors.

5. Dividend policies can change.

Dividends can be a great way of earning passive income, and if you invest in an ETF that comprises of dividend-paying stocks you could find yourself enjoying decent returns.

However, investing in an ETF and relying on dividend payments can be risky. That’s because the dividend policies of underlying companies could change in future leaving you worse off.

6. The liquidity risk.

If you invest in an ETF with a small asset base or low trading volumes, you could find it tricky to cash in your investments when you feel the time’s right to offload your holdings.

While this isn’t a major risk with most ETFs, if you’re looking to invest in a niche industry or sector it’s something worth bearing in mind.

How to invest in an ETF

Now we’ve covered what ETFs are and how they work, you may be wondering how to invest in one.

As mentioned above, one notable characteristic of ETFs is how easy they are to buy. Just like with stocks and shares, ETFs can be bought and sold on a stock exchange.

So, if you’re thinking of buying an ETF, you’ll first need to find a suitable brokerage account. As with any type of investing, always pay close attention to fees as hefty charges can eat into your returns.

Once you’ve chosen a brokerage account, you can then begin your search for a suitable ETF to invest in.

Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence. When investing your capital is at risk.

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Jasmine Birtles

Your money-making expert. Financial journalist, TV and radio personality.

Jasmine Birtles

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