What are ETFs?

An ETF (Exchange Traded Fund) is a hybrid between a fund and a share.

An ETF is like a conventional fund (a unit trust or OEIC) because it enables investors to put money in a range of assets with just one investment. The assets could be shares, bonds, property, commodities and more.

An ETF is like a share because unlike a conventional fund, it’s tradeable on a stock market.

One of the best known conventional funds in the UK is the Invesco Perpetual Income Fund. And there’s a lot to be said for the fund. It’s performed well over many years and it invests in a wide range of different companies – 117 at the time of writing. So investors get exposure to 117 different companies just by investing in one fund. Arguably, by investing in that one fund, you’ve already got a fairly diverse portfolio.

It’s also fairly easy to get your money out of the Invesco Perpetual fund. You can tell Invesco Perpetual that you want to take your money out, and they’ll give you your money back in a few days. However, you don’t know what price you’ll get for the units that you’re cashing in. That price will be set after you’ve given the instruction to sell. Either later on that day or the following morning. That’s because all unit trusts and OEICs set their unit prices just once a day.

Instead of approaching Invesco Perpetual, you could also cash in your units via your financial adviser or an online trading platform such as Hargreaves Lansdown. But you still won’t know what your sale price will be when you give the instruction to sell.

It’s different with an ETF. Let’s say that you invested in the Vanguard FTSE 100 ETF (VUKE). You could sell your shares at any time when the London Stock Exchange is trading. You’ll know the precise sale price when you trade and the ETF’s share price will probably move around during the day.

You can buy shares in an ETF at 10:30 AM, sell an hour later and buy back in after lunch. Now trading so frequently isn’t normally a good idea, but the flexibility is there if you want it.

And it’s very easy to buy and sell ETFs on the well known platforms. As well as Hargreaves Lansdown, other big names include The Share Centre, Barclays Stockbrokers and Interactive Investor. You can also put many ETFs in an ISA or Sipp.

Cheap and simple

ETFs have become increasingly popular over the last decade because they tend to be simple and cheap. The most popular ETFs normally track well-known stock market indices around the world. We’ve already mentioned the Vanguard FTSE 100 ETF – it invests in all one hundred shares in the Footsie. If the Footsie rises by 10%, the value of your share in the Vanguard ETF should rise by roughly 10% too. And with this ETF, you’ll only have to pay a 0.09% annual charge. In other words, if the value of your investment is ¬£1000, you’ll only pay 90p a year in charges.

Because the Vanguard ETF tracks the Footsie, it’s a passive fund. Most ETFs are passive. By contrast, the majority of unit trusts and OEICs are active, which means a highly paid fund manager picks the stocks and the fund doesn’t track an index.

The fact that most ETFs are passive is the main reason why ETFs normally charge low fees. There are low-charging ETFs tracking the S&P 500 index in the US, the Euro Stoxx 50 in Europe, and many other stock market indices around the world. Bond and property indices too.

ETFs that give you exposure to commodities, especially gold, have also been increasingly popular, and there are also more sophisticated ‘smart beta’ ETFs that enable you to follow particular investment strategies using ETFs. These ETFs are passive too.

Institutions

It’s not just private investors who put their money in ETFs. Big institutional investors like ETFs too – thanks to their low costs and flexibility. If a big pension fund wants to quickly increase its exposure to, say, Brazil; it can buy shares in a Brazil ETF without much hassle.

You can also implement various strategies with ETFs that have traditionally only been associated with shares. Things like selling short, placing stop-loss or limit orders, or even buying on margin.

Leveraged and inverse ETFs

A leveraged ETF is one that is supposed to rise by more than the rise in the underlying asset or index. So you might see a FTSE 100 (x2) leveraged ETF. If the FTSE 100 then rises by 10%, your investment in the leveraged ETF should rise by 20%

There also inverse ETFs. So a FTSE 100 inverse ETF would rise if the FTSE 100 fell.

However, these is a problem with these ETFs. They rebalance frequently, which means their price movements start to diverge quite quickly from the underlying index. As a result, they’re only appropriate for short-term traders, and risk-tolerant traders to boot.

Authorised Participants

One unique feature of ETFs is their creation and redemption process. In other words, the way that shares in the ETF are created and also sold back to the fund.

A crucial player in this process is the authorised participant or AP. APs are normally market makers or investment banks.

An AP signs up to support a particular ETF and it can then approach the ETF with assets that reflect the ETF’s composition. The AP can then demand shares in the ETF in exchange for those assets. So with a FTSE 100 ETF, the AP would hand over shares in FTSE 100 companies and get shares in the FTSE 100 ETF in return.

The AP can also hand in shares in the ETF in exchange for underlying assets. If the share price of an ETF moves out of line with the value of the underlying assets, the AP can make money via arbitrage. That arbitrage process means an ETF’s share price is normally very close to the Net Asset Value (NAV).

Investment trusts

One more thing before we finish: it’s possible you may be thinking that ETFs sound very similar to investment trusts. And if you’re thinking that: you’re right. Just like ETFs, investment trusts are investment funds that are traded on stock markets. What’s more, you can trade in and out of them and their prices move around during the day.

However, there are some significant differences too. The most important is that most ETFs are passive whereas the vast majority of investment trusts are active. Investment trusts are much older too – they’ve been around since the nineteenth century whereas the first ETF was launched in 1993.

Hopefully, you now feel you understand the basics of ETFs. You can learn more in our ‘Guides & Education’ section and across the ETFstream website.

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