Exchange-Traded Funds (ETFs)

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

Source: interactive investor. Past performance is not a guide to future performance.

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, such as the S&P 500, Dow Jones Industrial Average or FTSE 100.

Primarily, this is what they are still used for. 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.

ETFs usually track a basket of stocks or other assets. To do this they track the performance of a specific index, most commonly available from companies such as FTSE or MSCI.  

ETFs will provide the return of an index, minus their management fee. 

There are two types of ETF structure: physical and synthetic. The difference is a physical ETF will actually hold an asset, while a synthetic ETF simply tracks the asset. The ETF issuer enters into a swap contract with a counterparty to provide a return equivalent to that from the underlying asset. With this comes what is known as counterparty risk. This is something to be mindful of as the company issuing the derivatives could go bust and therefore you might lose some of your money.

ETFs now come in all shapes and sizes. The simplest are those that track long-established equity indices. There are also those that track bond market indices, a basket of commodities, baskets of currencies and property.

In recent years ETFs have become more niche. Investors can now find ETFs that offer exposure to increasingly specific baskets of equities or other assets.

Other ETFs track certain sectors within a wider index. For example, many popular ETFs track such such as the banks and financials sector in the S&P 500.

Some 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 is known as ‘smart beta’ in industry jargon. These ETFs do not track shares by market capitalisation, as a fund tracking, say, the FTSE 100 index would.

Instead, they actively decide which shares to track by targeting shares 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.

The primary advantage of ETFs is that they are low cost. Thanks to their unique structure and (usually) having no 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. 

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.

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 will (in vast majority of cases) not outperform the index it is tracking. Actively managed funds, run by fund managers, aim to provide outperformance, but there are no guarantees this will be achieved. 

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 that hold dividend paying stocks pay those out to investors. 

Generally, ETFs pay out the dividends of the stocks they own on a quarterly basis.

ETF investors can receive the proceeds of their dividends in either cash or additional units in the ETF in question. Many investors chose to reinvest their dividends to increase their holdings, allowing their dividends to compound. 

ETFs are listed on the London Stock Exchange, so you buy them through a platform like interactive investor. This means you need to factor in dealing costs.