An increasing focus on the cost of investing and disillusionment with the performance of active managers, plus greater choice, have buoyed the popularity of exchange traded funds (ETFs).
Below our beginner’s guide runs through the basics that investors need to get to grips with.
What are ETFs?
ETF stands for exchange-traded fund. Invented in the early 1990s, ETFs are investment funds that can be traded on stock exchanges in the same way equities are.
ETFs started their life as ways to track a broad basket of stocks using an index (explained below), such as the S&P 500, Dow Jones Industrial Average or FTSE 100.
Investors still mostly use ETFs to track these big name indices. However, over the years, ETFs have become more sophisticated. They now offer the ability to track a basket of a wide range of other asset classes such as bonds, property, currencies or commodities (such as gold and oil). They can also be used to track more niche baskets of stocks.
What is an index?
An index is a basket of assets, such as stocks, bonds or commodities, chosen to represent the performance of a market or an asset class. So, for example, the first index was created by Charles Dow in 1896, known as the Dow Jones Industrial Average. At the time, it included the 12 largest companies in the US and was designed to give an idea of the general direction of the US stock market. The index is still around today and includes 30 stocks.
- Henry Cobbe: the problem with active funds
- The Tom Bailey column: is passive investing destroying the stock market?
Since then, indices have expanded and become more sophisticated, but broadly serve the same purpose. So, the S&P 500, composed of 500 large US stocks, is primarily used as the gauge of the health and direction of the overall US stock market.
An index can also be used to gauge the performance of a particular type of stock, based on the criteria used to include stocks in the index. For example, the Nasdaq Composite index is taken a gauge for the general health of US technology stocks.
Usually, the goal of an ETF will be to provide a portfolio that mirrors an index, thereby providing the performance of that index (minus its fees).
Types of Exchange Traded Funds (ETFs)
As noted, most ETFs track long-established equity indices like the S&P 500 or FTSE 100. There are also those that track bond market indices, a basket of commodities, baskets of currencies and property.
But in recent years, ETFs have become more niche. There are now millions of different indices with all sorts of different rules to decide which stocks or assets are included – many of which ETFs now track.
For example, some ETFs track certain sectors within a wider index, such as financial stocks. Other ETFs track certain themes. For example, a popular theme in recent years has been cloud computing. A cloud computing ‘thematic’ ETF will usually track a cloud computing index, which will comprise companies deemed to be involved in cloud computing.
Another ETF option are ETFs using “smart beta” or “factor” strategies, in industry jargon. These ETFs do not track shares by market capitalisation, as a fund tracking, say, the FTSE 100 index would. Instead, they track an index which screens for stocks that possess certain characteristics. For example, some smart beta funds follow a basket of companies that are reliable dividend payers, while others target the highest yielding shares on a particular index.
Main advantages and disadvantaged when investing in ETFs.
The primary advantage of ETFs is that they are low cost. Thanks to their unique structure and (usually) having no active portfolio manager, they are much cheaper for investment houses to run. As a result, investors are charged less. Some popular ETFs charge as little as 0.05%, which works out at £5 on a £10,000 investment.
There is no stamp duty to pay when you buy an ETF.
Investors, though, need to look at the spread between the buying and selling price, though for most ETFs these are very small.
- Active versus passive: a brief introduction
- Diversifying your portfolio is easy with these ii Super 60 recommended funds
- Take control of your retirement planning with our award-winning, low-cost Self-Invested Personal Pension (SIPP)
Another attraction is simplicity. Investors who buy an ETF opt to simply ‘buy the market’ and their returns will mirror how the index performs, minus fees.
ETFs are also very liquid, so you won't have problems buying and selling usually. On top of this, unlike unit trusts, which are priced once a day, ETFs are priced throughout the day, so you get the price you see immediately.
Another key advantage of ETFs is that they offer access to previously hard to reach parts of the market for private investors. Prior to the invention of ETFs, investors would have struggled to find a way to gain exposure directly to the price of oil or be able to easily track a basket of value stocks.
The main disadvantage is that an ETF, by design, will not outperform the index it is tracking (usually). Actively managed funds, run by fund managers, aim to provide outperformance, but there are no guarantees this will be achieved.
Are ETFs good for beginners?
Beginner investors should consider using an ETF to gain exposure to major stock market indices. Broad exposure to main markets such as the S&P 500 or FTSE All Share is viewed as a sensible core part of any beginner investors portfolio. ETFs provide a cheap and easy way to do this. ETFs are listed on the London Stock Exchange, so you buy them through a platform like interactive investor.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.