Demystifying ETFs

Regular readers and viewers will notice that I regularly talk about ETFs, particularly in my website section on Investing and in the ETF section of my YouTube channel. But what actually are ETFs, and why are they a good option for you? Here, I’ll go into more detail on what ETFs are, how they work, the different types of ETFs and some of the benefits of them as an investment tool.

This will be the first in a series of blogs on investing. After this, I’ll look at other types of investments, the pros and cons of the different options and some of the best platforms for the type of investment you are interested in.

What is an ETF?

So, the simple question to start with – what are ETFs? ETF stands for ‘Exchange-Traded Funds’. They are a type of investment fund that trades on a stock exchange, much like a regular stock. An ETF holds a basket of assets, such as stocks, bonds, commodities, or a mix of these, and aims to track the performance of a particular index or sector. For example, some ETFs track broad market indices like the FTSE 100 or the S&P 500, while others might focus on specific sectors like technology or renewable energy.

How Do ETFs Work?

ETFs are designed to be a cost-effective and simple way to diversify your investment portfolio, giving you exposure to multiple assets within a single trade. When you buy shares in an ETF, you are buying a fraction of the entire portfolio of assets the ETF holds.

The principle is the same as regular investment in regular stocks and shares however, rather than being tracked against single companies, the price of an ETF share will move in line with all the underlying assets that form the ETF.

For example, let’s say you invest in an ETF that tracks the FTSE 100. The value of your ETF investment will rise and fall based on the performance of the FTSE 100 companies, in the same way that it would if you chose to invest in those companies individually.

ETFs can be passively managed or actively managed, and it’s important to understand the difference to know which approach is better for you.

• Passive ETFs: Passive ETFs aim to replicate the performance of an index or benchmark (e.g., the FTSE 100 or the S&P 500) by holding the same assets in the same proportions as the index they track. As the assets stay the same and don’t require active management, passive ETFs usually have lower fees.

• Active ETFs: As you have probably worked out, active ETFs are actively managed by fund managers, who will make decisions about which assets to buy or sell in order to outperform a benchmark. Given the, well, active nature of these, active ETFs tend to have higher management fees than passive ETFs.

  
  

Key Features and Benefits of ETFs

ETFs have become increasingly popular as an investment option and there are several key features that can make them a superb option for your portfolio. These include -

1. Diversification: By investing in an ETF, you gain exposure to a broad array of assets, which helps to spread risk. As an example, a global equity ETF might include hundreds of different companies from various countries, reducing the impact of any single stock’s performance on your overall portfolio.

2. Low Costs: ETFs generally have lower management fees than traditional mutual funds. This is especially true for passive ETFs, as they simply track an index rather than requiring active management.

3. Accessibility: ETFs can be bought and sold on major exchanges and can be purchased through online brokerage platforms, ISAs (Individual Savings Accounts), and pension schemes. They are an attractive option for UK investors looking for a simple and straightforward way to manage their investments.

4. Flexibility: Since ETFs trade on the stock exchange, they are more flexible than traditional funds. You can buy and sell shares anytime during trading hours, making them ideal for investors who want to be able to react quickly to market changes.

5. Low Minimum Investment: Unlike some mutual funds, ETFs have no minimum investment requirements beyond the price of one share, meaning they are suitable for investors with smaller amounts to invest.

6. Tax Efficiency: ETFs are typically more tax-efficient than mutual funds due to their structure. This is particularly advantageous for UK investors, as it can help reduce your capital gains tax liability when you sell your shares.

   
   

Types of ETFs Available

There are many different types of ETFs available to investors. Some of the most popular include:

• Equity ETFs: These ETFs track the performance of stock indices, such as the FTSE 100, FTSE 250, or global markets like the MSCI World Index. The justETF website recently posted a good article on why investing in global ETFs can be a good strategy, as well as looking at some of the different ETFs you could invest in.

• Bond ETFs: These ETFs invest in fixed-income securities like government and corporate bonds. These can be a safe, reliable option for providing a steady income stream.

• Sector ETFs: These track specific sectors of the economy, such as technology, healthcare, or energy. These allows investors to target growth in particular industries and can be a great option for targeting high-growth sectors early.

• Commodity ETFs: These ETFs invest in physical commodities, such as gold, oil, or agricultural products. Commodity ETFs provide exposure to the price movements of raw materials.

• Thematic ETFs: These focus on emerging trends or sectors, such as green energy, AI technology, or ESG (environmental, social, and governance) investing. These ETFs are popular for people interested in investing in areas that align with personal interests or philosophies.

• International ETFs: These allow you to invest in international markets, providing exposure to global economies like the US, Europe, or Asia. An example is the Vanguard Japan ETF, which I did a video on last year.

• Dividend ETFs: A dividend ETF is made up of dividend-paying stocks that usually track a dividend index. This ETF pays dividends to investors, which can be qualified or nonqualified. You can find out more about dividend ETFs in the video I previously did on them.

  
  

Conclusion

ETFs are an excellent investment option for you if you are looking to diversify your portfolio, gain exposure to a wide range of assets, and keep costs low. Whether you're new to investing or a seasoned pro, ETFs offer flexibility, transparency, and tax efficiency that can be appealing to all types of investors. By selecting the right ETFs for your financial goals, you can build a well-rounded investment strategy that suits your needs.

I hope this has been a useful introduction to ETFs. In the next blog, I’ll look at the more traditional mutual funds, before moving on to the pros and cons of both options, and the best platforms for you to invest depending on your portfolio.