What is an ETF?

Exchange-traded funds (or ETFs) are a convenient way for investors to invest in a basket of shares, and/or bonds, and/or commodities that make up a particular index or theme. They are like open-ended funds such as unit trusts and OEICs in terms of where they can invest, but they differ in that they are listed on the stock market and can be traded in ‘real time’ during market hours. Funds, on the other hand, can only be bought and sold for a price that is set once a day.

Typically, ETFs are designed to replicate the performance of a chosen index, which can be a broad market such as the FTSE 100 or the MSCI World or much more targeted such as a certain sector. Other exchange-traded products (known as exchange traded commodities (ETCs) track other things such as gold or oil, or currencies.

Like all stock market investments, the value of an ETF will rise and fall and neither the capital nor income is guaranteed. In addition, each ETF is exposed to a mixture of risks related to its asset class and method of investing. The full details of the risks of a particular ETF can be found in the relevant Key Investor Information Document (KIID) and Simplified Prospectus. These can be found in the Key Features and Documents tab on the ETF’s page on the Charles Stanley Direct website.

How do ETFs work?

As mentioned, index-tracking ETFs work by replicating the performance of an index. There are two ways in which they do this: physical and synthetic. Physical ETFs are the most straightforward because they hold all the constituents of an index, or a representative sample. Synthetic ETFs, meanwhile, use complex financial instruments called derivatives to replicate the performance of the index, usually in the form of a ‘swap’. This is where the ETF enters into a contractual agreement with a counterparty who agree to pay the return of the index minus a fee.

Although this can bring some extra risk that the counterparty can’t honour its commitment, synthetic products can be useful to access harder-to-reach markets or assets where physical holdings aren’t practical, for instance most commodities. For synthetic ETF products, there is collateral held which helps protect against the risk of the counterparty not being able to honour the return of the index. Whether an ETF is physically or synthetically based will be detailed in its Key Investor Information Document (KIID) and factsheet.

What are the benefits of ETFs?

ETFs offer several benefits including variety and the ability to spread your risk across multiple investments. These are the main reasons why many investors add ETFs to their portfolios.

1. Very wide choice – there’s an ETF for many indexes or themes you can think of. This allows investors to tailor a portfolio to their requirements very precisely.
2. Diversification – a single broad ETF offers access to hundreds, sometimes thousands, of individual securities, and by investing in a portfolio, ETFs can help you build a diverse portfolio easily to spread risk.
3. Low cost – there is a competitive landscape for these products among the large, global asset management companies. Passive management through ETFs is also typically low cost compared to actively managed funds, although ETFs are designed to track the return of the index minus costs (OCF of the ETF).
4. Real time trading – ETFs are traded throughout the day unlike funds, so you can buy them at the precise time of your choosing.
5. Tax efficiency – you can hold ETFs in a tax-efficient account such as an ISA or SIPP so there is no income or capital gains tax to pay. In addition, when buying and selling ETFs on the secondary stock market investors aren’t subject to stamp duty which investors would normally pay if they were buying shares in individual companies.

What are the risks of ETFs investing?

It’s just as important to consider ETF risks, which helps to avoid any unforeseen investment mistakes.

1. Volatility – The share prices of ETFs that are narrowly focussed on a niche market or narrow theme may experience a high degree of ups and downs. Some products are highly concentrated in a small number of stocks because they dominate the index being tracked.
2. Complexity – many ETFs are straightforward, but others are highly complex, including ones that are only available to sophisticated investors because they use complicated strategies, leverage or derivatives where the return of the ETF is the opposite of the index. Before buying always read the documentation, including the KIID, carefully to ensure you understand the product.
3. Pricing – Retail investors will most likely buy an ETF at a slightly higher price than its sale price. The difference between these two prices, known as the ‘spread’ will be affected by various factors like market volatility and the liquidity in the underlying stocks. Although it is sometimes overlooked, a competitive spread can be a really important factor in choosing an ETF. In adverse market conditions it might widen, and in extreme cases an ETF might trade at a discount or a premium to the value of its assets.
4. Fads – there can be a tendency for more targeted niche ETFs to be launched to reflect the ‘flavour of the month’ among investors, which may subsequently go on to disappoint as the crowd moves on. An appealing theme can draw attention to niche ETFs, but their narrow focus means they should only ever be very small holdings in a portfolio.
5. Not eligible for FSCS – Most ETFs are domiciled in Europe and therefore investors are not typically protected by the UK’s Financial Services Compensation Scheme (FSCS), a fund available to compensate consumers if an authorised financial services provider cannot meet claims against it.

ETFs on the Preferred Fund list

ETFs on our Preferred List - our list of investment ideas for products which offer low cost exposure to popular investment areas and represent possible options for straightforward portfolio building blocks. They have been selected by our Collectives Research Team for their transparency, low charges and typically narrow trading spreads.