There are two main ways for retail investors to gain exposure to the stock market.
One is to build up a portfolio of investments by buying shares directly in individual companies. For all but the most dedicated do-it-yourself investors, however, the process can be time-consuming and risky.
The risk is that an investor relying on just a concentrated handful of shares from which to make their fortune might see a single corporate failure have a disproportionate impact on their portfolio’s overall performance.
A second, more diversified, way of owning stocks and shares is by investing in ‘collective’ investments such as exchange-traded funds, which pool the money of like-minded investors, with a finance professional managing the fund on their behalf.
Here’s a look at how exchange-traded funds work, why they might be suitable for you, and what to bear in mind should you decide to include them in your portfolio.
Note: all investing is speculative, your capital is at risk, and you could lose some or all of your money.
What is an exchange-traded fund?
An exchange-traded fund (ETF) enables investors to access stock and commodities markets without requiring the share-picking skills associated with selecting individual company stocks.
This is because ETFs focus less on individual businesses and more on a collection of the main investments within a particular market or industrial sector, or other assets such as commodities.
ETFs were developed during the 1990s and first appeared on the London market in April 2000. Sinced then, they have enjoyed plenty of traction with investors. According to data provider EPFR, more than £7 trillion was invested in ETFs worldwide in 2021.
Younger investors are particularly drawn to ETFs. According to asset manager WisdomTree, more than a third (36%) of UK investors aged between 18 and 34 hold ETFs. This figure drops to around 5% among investors aged 55 or older.
How do ETFs work?
Exchange-traded funds combine the characteristics of a share with that of an index tracker fund.
Shares provide a slice of ownership of a particular business. An index tracker fund is a collective investment that uses computer algorithms to help it to invest in all the companies within a particular stock market index or industrial sector with the aim of reproducing its performance.
This might be the FTSE 100 index of the UK’s largest companies, for example, or businesses involved in a sector such as healthcare or mining.
With ETFs, an investment management firm buys a basket of assets (shares, bonds, etc) to create the fund. It then sells shares that track the value of the fund, which is determined by the performance of the underlying assets. These shares can be traded on markets in the same way as stocks.
Buying shares in an ETF doesn’t mean you own a portion of the underlying assets in the way you would when buying shares directly in a company. The firm that runs the ETF owns the assets and adjusts the number of associated ETF shares to keep their price synchronised with the value of the underlying assets or index.
So-called ‘physical’ ETFs hold the assets linked to the index in question and, as with index trackers, either replicate the index in full or rely on a technique called ‘sampling’.
‘Swap-based’ or ‘synthetic’ ETFs use financial instruments called derivatives to follow an index. In this scenario, an ETF provides a basket of securities as collateral to a financial institution (such as an investment bank) in return for a ‘swap’ contract.
The ‘swap’ is a guarantee by the institution to pay out the return of the required index, in exchange for the performance of the collateral. An ETF provider’s website will tell you whether it offers physical or swap-based products.
As with other types of shares, it’s possible to apply ‘stop’, ‘limit’ and ‘open’ orders when buying ETFs. These are brokerage instructions that apply when certain prices are reached and are designed to head off any nasty surprises for a would-be investor.
One point to note about ETFs is that they have the potential to encourage investors to trade more frequently than they may have expected. This could ultimately result in higher costs (see below).
ETFs and crypto
In 2021, the US was one of the world’s first jurisdictions to provide the regulatory green light to cryptocurrency ETFs. These give investors the opportunity of gaining exposure to crypto assets without having to store the coins themselves.
Crypto ETFs are not currently available via the London stock exchange.
What is the appeal of ETFs?
ETFs are ‘passive’ funds in that they replicate an existing index, say, without the need for ‘active’ asset selection, making them cheaper to own because they cost less to run. The less investors fork out in management fees, the more their money has the power to boost returns.
As well as competitive charges, ETFs also offer investors diversification, which helps defend from stock market shocks by spreading money around different sectors.
Stock market indices contain dozens, hundreds, or even thousands of companies. Many ETFs provide exposure to large numbers of these businesses simultaneously, which is easier than taking out lots of individual shareholdings to achieve the same effect.
ETFs of all varieties
According to the London Stock Exchange, there are currently more than 1,500 ETFs listed on its main market from around 50 issuers. Researchers at Statista say there were around 8,500 ETFs in circulation worldwide during 2021.
ETFs have been put together based on almost every kind of security or asset that are available in financial markets.
For example, stock ETFs track shares of companies in one industrial sector (such as healthcare). Bond ETFs invest in debt such as that issued by governments (gilts in the UK, Treasuries in the US), or loans issued by companies (corporate bonds).
Foreign exchange ETFs buy currencies and hybrid ETFs mix and match asset types.
What’s the difference between an ETF and an index tracker?
Pooled arrangements such as unit trusts and tracker funds are priced once a day. But since an ETF is traded directly on a stock exchange and can be bought or sold at any time during normal market hours, it has a fluctuating ‘live’ price.
This gives ETFs extra flexibility and makes them more liquid (tradable) than a conventional index tracker fund.
What’s an exchange-traded commodity?
Exchange-traded commodities (ETCs) are similar to ETFs but, rather than track stock market indices, they follow the performance of commodities such as gold. The easiest way to do this is for the ETC to hold the commodity in question in a tangible form – such as gold bullion. This is known as a ‘physical ETC’.
An alternative approach is to rely on financial instruments called derivatives to copy the rise and fall in the price of a commodity. These are known as ‘synthetic ETCs’.
How can I invest in ETFs?
The most convenient way to buy ETFs is via an online investment platform.
Before signing up, you’ll need to decide what sort of investments you want to buy. Are you aiming to follow global companies that make up a world stock market index? Or is your preference for a particular country’s stocks, such as those based in the UK or US? Maybe your focus is on businesses involved in specific sectors such as technology, mining or healthcare.
You can read more here about how to find a selection of ETFs picked by an expert aimed at different investor profiles and focusing on factors such as the investment process and running costs.
You can find out more about ETFs that hold stocks with a strong history of paying dividends to their shareholders here.
What do passive funds and ETFs cost?
As noted above, passive investments tend to be cheaper than their actively-managed cousins.
However, you still need to pay an annual fee to cover an index fund’s costs. The average expense ratio of passively managed funds – the amount that investors are charged – stood at around 0.06% in 2020, according to the Investment Company Institute.
This compared with a figure more than 10 times that amount (0.71%) for actively-managed US funds. Applying these figures, a £10,000 investment in a passive and active fund would cost £6 and £71 respectively.
In this example, additional charges for dealing, etc, may also apply depending on where the fund was bought. This might be through an investing platform, trading app, or via a financial advisor.
Whichever the preferred channel, charges eat into your investments’ capacity to make money, so it’s wise, all else being equal, to pick a service that’s the most cost-effective for your needs.
As well as the initial cost of the ETF, expect to pay an annual fund charge. If you buy an ETF via an investing platform, look out for platform provider charges, which come in a variety of guises from ‘per transaction’ or based on the size of your investment portfolio.
When buying company shares listed on, say, the London Stock Exchange, investors incur a stamp duty charge of 0.5% of the transaction. However, despite being traded on exchanges, ETFs are exempt from stamp duty in most jurisdictions, including the UK.
As with individual stocks and shares and other types of fund, it’s possible to hold ETFs within a tax-protected product such as an Individual Savings Account, or ISA. Doing this shields you from paying income tax on dividends or capital gains tax on any profits.
Read More: What Are ETFs (Exchange-Traded Funds)?