What are ETFs?

Exchange-Traded Funds (“ETFs”) are one of the most popular investment products today. Investors throughout the world have adopted ETFs for their many benefits such as quick diversification, low costs, and easy trading.

As their name suggests, ETFs have two defining characteristics: they are funds, and they trade on an exchange, sounds simple, right? Here’s a quick guide to help you get to know ETFs even better.

What is a fund?

ETFs are just funds that trade on a stock exchange like a regular share.

There are over 100,000 publicly-traded companies in the world – companies that have shares listed on an exchange.

ETFs, just like traditional mutual funds, group together stocks that have similar characteristics, enabling the investor to buy purchase hundred, or even thousands of shares in one go. The way the fund plans to invest, and the types of companies they will invest in will be outlined in the fund’s investment prospectus.

Examples of how shares can be grouped:

Geography:

• Market Status: Developed or Emerging Markets
• Regions: e.g. Europe, North America, Asia-Pacific, Africa
• Single Countries e.g. UK, Canada, Japan

Company characteristics:

• Industry: e.g. Healthcare, Technology, Energy, Defence, Banking
• Size: Large, Mid or Small
• Style: Growth, Value

Themes and Sustainability:

• Environmental leadership / impact
• ESG rating
• Upcoming themes e.g. Medical cannabis, space, e-sports, pet care, video games, robotics, clean energy, battery technology

Now, mutual funds used to be the most commonly bought fund product – this would be what your parents or even grandparents would have invested in - but ETFs are rapidly replacing mutual funds in many personal and professional investment portfolios as they are typically cheaper than mutual funds, can be traded at any time that the exchange is open (unlike mutual funds that only traded once a day) and often have lower minimum investment levels meaning smaller investors can participate in the markets. 

As ETFs contain multiple securities, they are also good for investors who don’t want to put all their eggs in one basket, and because ETFs trade on stock exchanges they can be bought and sold as easily as a share. Read more about diversification here.

What is an exchange-traded fund?

ETFs are a specific type of fund that are listed and traded on exchanges. This characteristic has many benefits for investors and makes buying and selling shares of ETFs easier and faster than traditional funds.

What is an exchange?

An exchange is a marketplace where investors can buy and sell company shares or other financial instruments, like ETFs. Famous examples of exchanges include the New York Stock Exchange (NYSE) and Nasdaq in the US, the London Stock Exchange (LSE) and Euronext in Europe or the Tokyo Stock Exchange in Asia. Read more about exchanges.

Through an exchange, investors can buy or sell shares of ETFs just like company stocks. Unlike other types of funds that are priced and trade only once per day (at the close of the markets), ETFs trade in real-time throughout the trading day (at any time the exchange is open). This brings a lot of transparency and flexibility for investors and allows them to buy or sell quickly at a price that is known. For example, ETFs allow investors to sell fast in a crisis, or buy without delay when opportunities arise in the market.

What is a passive fund?

Passive funds, also called index funds, are funds that seek to replicate the performance of an index.

What is an index?

An index acts like a thermometer for a particular market. It tells you if the market is, on average, going up or going down. Indexes are not directly investible. They are simply a calculation that reflects the average performance of the stocks.

Investors cannot buy an index directly, but they can buy index funds. The index rules will decide which companies the fund will buy. In this way, indexes act as a recipe for passive funds - showing what ingredients are needed and how much to add.

The most well-known index is probably the S&P 500. It tracks the performance of the 500 largest U.S. companies. If you want to invest in US stocks, but don’t want to pick favorites, then ETFs which copy the S&P 500 give you a way to buy the largest companies driving the market in one go. Other famous indexes include the FTSE 100 for UK stocks, Euro Stoxx 50 for European stocks. There are also more global indices like the MSCI World or MSCI Emerging Markets.

It’s a common misconception, but not all ETFs are passively managed. While most ETFs simply replicate an index, some ETFs allow you to buy into a selection of securities chosen by a professional investor. These are known as active ETFs because the professional is actively choosing the securities, not following a recipe from an index. Read more about active ETFs here or skip the theory and see all active ETFs available in your region.

Identify ETFs like a pro

It is easy to feel lost when looking at the 7,000+ ETFs available around the world. However, ETFs use the same naming convention across the globe. We break it down for you.

ETF names often start with the name of the ETF provider. The ETF provider is an asset management company that creates, sells and markets ETFs.

Then if the ETF is passive and tracks an index, the index provider name will be included – or at least part of it. Index providers are companies that design and calculate indexes. Read more about index providers.

Following is the index name. Usually quite explanatory. It can be a number when the index is taking a portion of a market (like the S&P 500 or FTSE 100), or it can be the geographical focus or any other attributes of the securities included in the index (like MSCI Emerging Markets or MSCI World Small Cap).

ETF names can also include more details at the end. Those details can include the share class dividend policy (distributing or accumulating), the hedging policy for foreign currency exposures (hedged or not), as well as the currency of the fund (the currency in which the share price is stated officially, like USD or EUR for example).

Example: SPDR S&P 500 ETF – USD

 Why are ETFs popular?

ETFs are good in many ways. They are often preferred by investors over other types of funds as they offer a variety of unique benefits, such as tradability, diversification, transparency and low costs:

• Tradability: The price of an ETF will change throughout that trading day as the prices of the stocks it contains rise and fall. ETFs can be bought or sold at any time the exchange is open, meaning traders can use ETFs to take advantage of these short-term price moves. In contrast, mutual funds only trade once a day, after the exchange is closed.
• Diversification: The huge range of ETFs available makes it straightforward to build a portfolio that contains hundreds or thousands of securities. This means investors can spread their risk much more broadly compared to investing in a single stock.
• Transparency: You can normally look inside an ETF and see exactly what you are buying, unlike mutual funds that usually only show their top 10 stocks.
• Low Costs: ETFs normally charge very low fees, especially when compared to mutual funds, meaning when you invest in an ETF, you keep more of your money. You also don’t need a huge amount of money to get started, meaning you can build a portfolio of ETFs for just a few hundred pounds. 

Why are ETFs tax efficient?

Issuers may structure an ETF in a way that delivers an optimal tax efficiency for investors. This is achieved by the ETF provider when they create the ETF. To increase the tax efficiency of their products, ETF providers can play on criteria such as the replication approach, the income treatment, the fund domicile, and tax statuses.

What risks are there in ETFs?

While ETFs offer advantages to investors, they’re not a magic wand that guarantees you will make money. Like all investments, ETFs have the potential to go down in price and you should understand the following risks before buying an ETF:

• Capital risk: like all investment products, the value of an ETF can go down as well as up. Not all ETFs are suitable for all investors. The price of the investments may go up or down and the investor may not get back the amount invested.  
• Tracking risk: even after charges are considered, ETFs may not track an index perfectly. The difference between the return of the ETF and the return of the index is called ‘tracking difference’. The variation in daily excess returns between the ETF and the index is called ‘tracking risk’.  
• Income risk: the income associated with a distributing ETF share class is not fixed and may fluctuate.
• Currency risk: ETFs involving exposure to foreign currencies can be affected by exchange rate movements. This means changes in the value of foreign currencies can impact the value of shares that are bought and sold in that currency. For example, an American investor who buys an ETF that invests in Japanese stocks will see the value of their ETF change if either the price of the stocks changes or if the exchange rate between USD and Yen changes.
• Taxation risk: The levels and bases of, and reliefs from, taxation can change depending on investors’ fiscal situation.

There may be other risks that are specific to the exposure of an ETF – for example frontier market risk, sector risk or credit risk. Each ETF issuer should specify these risks in the documentation on their websites. Investors should refer to the ETF documentation before investing in the ETF.

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