What is an ETF and how they work?

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Exchange-traded funds (ETF) are among the most significant and versatile investment products introduced in the past few decades. With nearly 30 years of existence, ETFs offer numerous advantages, and when used correctly with the right strategy, they can be a robust vehicle to achieve your investment goals.

What is an ETF

Definition and Origin of ETFs

What is an ETF?

Exchange-traded funds (ETFs) are hybrid investment vehicles that combine elements of investment funds and stocks. They aim to replicate an index and can be traded on the stock exchange like regular stocks. Unlike traditional investment funds, which are subscribed and settled at net asset value after the close of each session, ETFs have a trading symbol (ticker) and trade in real-time.

Like investment funds, ETFs invest in a basket of assets (stocks, bonds, currencies, etc.), promoting risk diversification. However, despite their internal diversification, some ETFs may face concentration risk if they focus on a single industry or niche.

Origin of ETFs

In 1992, Nate Most proposed creating an instrument that was cheaper, more efficient, and easier to buy and sell than indexed investment funds. Despite initial rejection from Vanguard’s founder, John Bogle, Most successfully developed the first ETF, the SPDR S&P 500 ETF (SPY), with State Street in 1993.

Initially, all ETFs were passively managed, following an index. Recently, a new generation of actively managed ETFs has emerged, managed discretionarily by managers but retaining the benefits of the ETF structure, such as transparency and efficiency in operational and tax costs.

This article will focus on passively managed ETFs.

Differences with Mutual Funds

The main distinction between ETFs and Mutual Funds lies in the term «Traded,» meaning ETFs trade like stocks and can be bought and sold anytime the market is open. This is not possible with investment funds.

Other differences include:

  • Real-time Net Asset Value (iNAV): ETFs’ net asset value is known at every moment.
  • Lower fees: ETFs generally have lower fees due to more efficient internal operations.
  • Creation and redemption process: This makes ETFs more efficient and versatile, both fiscally and operationally.
  • Broader range of exposures and strategies: ETFs offer various market exposures and investment strategies.

 

Types of Replica on ETFs

There are two main types of ETF replication:

  • Physical replication: The manager buys the underlying securities of the index to be replicated.
  • Synthetic replication: The manager buys a swap contract with an investment bank, which pays the index’s return.

Many investors prefer physical replication due to actual ownership of the underlying assets. Synthetic replication introduces counterparty risk.

Within physical replication, methods include:

  • Full replication: Buying all the underlying assets of the index.
  • Optimised or sampling replication: Buying a representative selection of the total index portfolio to save operational costs.

ETFs can provide exposure to various markets, regions, sectors, and strategies. Examples include:

  • S&P 500 ETFs: SPDR S&P 500 ETF (SPY)
  • Thematic ETFs: Lithium & Battery Tech ETF (LIT), Cannabis ETF (POTX)
  • Commodity ETFs: Global X Uranium UCITS ETF, Xtrackers IE Physical Silver EUR Hedged ETC

Pros and Cons of ETFs

Pros

ETFs offer numerous benefits, including:

  • Diversification: Investing in a basket of stocks reduces risk compared to individual stocks.
  • Transparency, flexibility, and simplicity in trading: Real-time buy-sell operations and constant value updates.
  • Cost efficiency: Lower fees compared to investment funds.
  • Similar long-term performance to indices: ETFs aim for performance similar to the index minus fees by replicating an index.
  • Leverage and short investment options: ETFs allow for leveraged and short investments, offering speculative opportunities.

Cons

Despite their benefits, ETFs have some drawbacks:

  • Less favourable taxation: In the UK, ETFs are taxed like stocks, lacking the tax advantages of investment funds. For more information, check ETF Taxation in the UK.
  • Transaction costs: Broker fees for buying and selling ETFs can add up.
  • Complexity: The variety and sophistication of ETFs require investors to be well-informed.

Types of ETFs

ETFs can be categorised based on the assets they replicate:

  • Equity ETFs by Regions: iShares Core MSCI World UCITS ETF (SWDA)
  • Fixed Income ETFs: Xtrackers Eurozone Government Bond Yield Plus 1-3 UCITS ETF
  • Sector ETFs: Xtrackers MSCI World Information Technology UCITS ETF
  • Commodity ETFs: Global X Uranium UCITS ETF
  • Currency ETFs: Invesco DB US Dollar Index Bullish Fund (UUP)
  • Inverse ETFs: ProShares UltraPro Short QQQ (SQQQ)
  • Leveraged ETFs: Direxion Daily Semiconductor Bull 3x Shares (SOXL)
  • Country ETFs: Xtrackers MSCI Pakistan Swap UCITS ETF
  • Strategy ETFs: Global X XYLD S&P 500 Covered Call ETF
  • Thematic ETFs: Global X RNRG Renewable Energy Producers ETF

How to Invest in ETFs?

Understanding ETF concepts and how to acquire them is crucial. Creating an ETF portfolio depends on your investor profile and needs.

Investing in ETFs requires careful consideration of various factors to align with your investment goals and risk tolerance. Here are the key steps and considerations:

  1. Understand Your Investment Goals and Risk Tolerance:
    • Determine what you aim to achieve with your investment. Are you looking for long-term growth, income, or short-term gains?
    • Assess your risk tolerance. ETFs can vary in risk levels based on their underlying assets and strategies.
  2. Choose the Right Type of ETF:
    • Equity ETFs: For stock exposure, consider regional, sector, or thematic ETFs.
    • Fixed Income ETFs: For bonds and other debt securities.
    • Commodity ETFs: For investments in physical commodities like gold or oil.
    • Currency ETFs: For exposure to foreign currencies.
    • Inverse and Leveraged ETFs: For advanced strategies, including betting against the market or magnifying gains and losses.
  3. Research and Compare ETFs:
    • Look at the ETF’s underlying index and its historical performance.
    • Consider the ETF’s expense ratio, as lower fees can enhance your returns over time.
    • Review the ETF’s liquidity and bid-ask spread to ensure you can buy and sell easily.
  4. Consider the Tax Implications:
    • In the UK, ETFs are taxed like stocks, which means you’ll pay capital gains tax when you sell at a profit. Unlike investment funds, ETFs do not benefit from tax-free transfers between funds.
  5. Select a Reputable Broker:
    • Choose a broker with low commission fees and a user-friendly platform.
    • Ensure the broker offers a wide range of ETFs and provides tools for research and analysis.
  6. Build a Diversified Portfolio:
    • Spread your investments across different ETFs to reduce risk.
    • Balance your portfolio with a mix of asset classes and regions to mitigate the impact of market volatility.
  7. Monitor Your Investments:
    • Regularly review your ETF holdings to ensure they align with your investment goals.
    • Stay informed about market trends and economic factors that could affect your ETFs.

Tips for Investing in ETFs:

  • Identify ETFs suitable for long-term and short-term strategies.
  • Understand the dispersion of historical returns.
  • Avoid falling for passing trends.
  • Recognise that revolutionary ideas are not always good investments.

For more information, read How to Choose an ETF

Best Brokers for ETFs

ETFs are mainly traded through brokerage platforms. Searching for a broker with low commissions is especially important as sometimes the buy-sell commissions can be high. Therefore, analysing which is the cheapest broker to buy ETFs is important. Here we offer a list of some that offer ETFs towards UK users:

 

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