The financial world is awash with abbreviations, and one such you’ve probably heard of is ETFs. ETFs have become an increasingly popular choice among investors over the past decade, looking to build a diversified but low-cost portfolio - but have you ever wondered what they are? We’ll cover exactly that and some ETF basics below.
What are ETFs?
An ETF (Exchange-Traded Fund) helps investors invest in a collection of assets, like stocks (shares), bonds, and commodities, in one package. They typically track the performance of a specific index, sector, or asset class and trade on stock exchanges, as individual stocks do. ETFs provide a convenient and cost-effective way for investors to diversify their portfolios and gain exposure to various markets or investment strategies without having to own the underlying assets individually.
How do ETFs work?
Financial institutions create ETFs by pooling investor money to purchase a basket of multiple different shares, bonds, or other assets that match a certain investment focus. Investors can then buy the ETF and gain immediate exposure to a multitude of shares, for example, in one ETF, instead of buying a handful of individual shares.
When were ETFs first introduced?
The first ETF was introduced in the US in 1993. The Standard & Poor's Depositary Receipts, known as SPDRs, was launched by State Street Global Advisors and aimed to track the performance of the S&P 500 index. Since then, the popularity of ETFs has grown substantially, and they have become a widely used investment vehicle globally, with an estimated 8,000+ different ETFs available on the global markets.
What are the advantages of ETFs?
The nature of ETFs means investors gain instant diversification as they buy a collection of assets in one go, as opposed to investing in them one at a time, individually. Diversification can be an effective way to reduce risk while maximising potential returns.
It’s usually much cheaper, and quicker to buy an ETF, than buy the underlying holdings of the ETF individually, one at a time. This is particularly the case when it comes to investment platforms that charge trading fees, where instead of paying x4 sets of fees for buying shares such as Barclays, HSBC, NatWest, and Lloyds, you could buy one ETF that holds the very same shares and only have to pay trading fees once.
Similar to shares
ETFs trade on stock exchanges like the London Stock Exchange, or NASDAQ in the same way shares of companies do. This means you can buy, sell, and hold ETFs in pretty much the same way.
When it comes to ETFs you can always see what the underlying investments in the ETF are and in what proportion. This isn’t always the case in some investment instruments, like a managed fund, where it can be up to the fund manager whether or not to disclose holdings.
What are the disadvantages of ETFs?
Fees and commissions
While we’ve just praised the cost effectiveness of ETFs it is important to note each one is different. Costs can vary greatly between ETF providers and the platforms you use to access them. ETFs may also include commissions, management fees, and other expenses that can lower your returns.
This essentially means, how readily and easily an asset, like an ETF in this case, is bought and sold. Not all ETFs share the same level of liquidity, so it can take longer than expected in some cases to buy and sell your holdings. This isn’t ETF exclusive however, all asset classes and types have different liquidity and it is an important factor to consider in your investing.
As with all financial investments, investing in ETFs involves real risk. Prices of ETFs can go down as well as up and you could end up with less than you started with.
What type of ETFs are there?
Industry sector ETF
This type will give investors exposure to a range of shares in specific sectors. A technology ETF, for example, could be a basket of Meta, Amazon, and Apple stock - thus giving an investor broad tech market exposure, through a single investment in the given ETF.
These types of ETFs can include a specific commodity such as a Gold ETF, just holding gold-related companies, solid gold and or gold derivatives, or multiple commodities such as a precious metals ETF, that may hold gold, silver, and palladium.
Inverse ETFs, or Short ETFs are designed to perform inversely to the index they track. For example, an inverse FTSE 100 ETF, would track the FTSE 100 index with inverted (opposite) returns. So, if the FTSE fell, the ETF would rise by about the same percentage, and so on.
Where can I invest in ETFs?
Given the popularity of ETFs, you can access them on most investment platforms that offer share dealing and investing. Discover some market leading platforms on our ETF comparison page here. Not all providers do offer access, so make sure to double-check this before opening an account.
Before you invest in ETFs
Before making any investments, you must understand the risks involved and only invest money you can afford to lose. Do your research or consult with a qualified financial advisor if you need expert support.
What’s the bottom line?
ETFs are an effective, straightforward way to build diversity into your investment portfolio, as you get exposure to a whole range of assets in one go. They are a popular choice for beginner and advanced investors alike, although, like with all investing, it is important to do your research and know the risks before investing in ETFs.
Interested in investing but don’t know exactly where to start? We would always recommend practising without any real money before you start. Try the Pluto demo (no real money) environment on the free Pluto app.