What is an Exchange Traded Fund (ETF)?

Ricky Banham
Financial Planning

Diversification is of paramount importance in investment success, and one way to achieve it is by buying ‘Exchange Traded Funds’, or ETFs

ETFs can be an extremely useful and low-cost way to gain exposure to all sorts of markets and investment assets, but they also vary in complexity and risk.

Here are answers to some of the most frequently asked questions about these investments:

What is an ETF?

Let’s start with – what it is! An ETF is an individual stock that is bought and sold on a stock exchange; however, the stock itself tracks the performance of hundreds, or sometimes thousands of individual companies or commodities, so it acts like a tracker fund.

One of the benefits of an ETF, is that, unlike other funds which are priced daily, the price of an ETF moves like other share prices, so investors know what price they are buying at. ETFs can also be a very cost-effective investment instrument, as they lack an ‘active’ manager in most cases. You can source an actively managed ETF, but in doing so, these will cost more, as the manager is seeking to outperform an index, rather than track it.

One of the main reasons to use ETFs is to gain exposure to markets that are otherwise hard to access as an individual investor - such as infrastructure, oil price, or an overseas stock exchange.

What can an ETF track?

It is possible to find ETFs that track almost any index that you could think of, from the ‘FTSE 100’ to companies involved in ‘blockchain technology’. ETFs can track the price of commodities, such as gold, copper, or the price of beef! There is an ‘Agricultural Commodities’ ETF that invests in companies that produce agriculture products, such as grains, dairy, and livestock. These funds can invest in a bundle of commodity types or focus on one specific commodity.

Some ETFs track a particular theme - for example, businesses operating in Artificial Intelligence or adhering to certain ESG (Environmental, Social, and Corporate Governance) principles.

Essentially, ETFs can be either very simple or very complex, so it is important to understand exactly how an individual fund works before investing.

How risky are ETFs?

There are many different types of ETF, and some are riskier than others. For example, an ETF tracking a bond market is likely to be less volatile than one tracking the performance of the FTSE 100. Moreover, those tracking the more esoteric markets or commodities are more volatile, as you would expect.

Some ETFs are physical - they hold the actual stocks or commodities that they are tracking, allowing them to replicate performance like-for-like. Others are known as ‘synthetic’ ETFs – this means they replicate the performance of an index using a series of complex financial instruments. Synthetic ETFs make it easier to track hard-to-reach markets, or those where it is not easy to buy and sell an asset.

Are ETFs tax-efficient?

In the UK, the taxation works in much the same way as other investment funds. It is possible to hold them in either an ISA or a pension for maximum tax efficiency, and there is no stamp duty when you buy or sell an ETF.

Used, as part of a well diverse investment strategy, ETFs can be an integral part of any successful portfolio - providing the appropriate research is undertaken prior to investment.

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