What are ETFs?

ETFs explained: What are ETFs?

ETFs (or Exchange Traded Funds) are a low-cost (and relatively low-risk) way to start investing. And because they offer the flexibility of stocks and the diversifying benefits of mutual funds, ETF investments can be used to strengthen your portfolio.

How do ETFs work?

ETFs are a type of fund that lets you buy a basket of stocks that fit with a set of rules (known as an index), instead of employing a fund manager to pick individual stocks. When you invest in an ETF, you get a bundle of assets, which you can then buy and sell on a stock exchange at different prices.

Assuming a typical ETF represents 50-100 individual stocks, buying five ETFs could give you exposure to 250-500 individual companies that will automatically be bought and sold according to the index rules. But as an investor, you would only have five holdings in your portfolio and five transactions.

ETFs are much easier to trade than other funds because you can buy and sell them at any time of day. This is the main difference between ETFs and mutual funds, which can only trade once a day at a calculated price (known as the net asset value).

Another reason why ETFs are so popular amongst investors is that they offer transparency since most ETFs will publish their holdings daily (rather than quarterly). Additionally, ETFs can be more tax efficient than other funds, because they usually generate a lower level of capital gain.

Since ETFs don’t have to pay expensive fund managers or research teams, they’re also usually cheaper to buy than other funds. In this way, they’re an effective and affordable means of diversifying an investment portfolio.

Example: FTSE 100 ETF

The FTSE 100 Index is a list of the 100 largest companies listed on the London Stock Exchange, featuring businesses like HSBC and Tesco. An ETF designed to track this index will buy the same 100 stocks in the same proportion as the index. So, if HSBC is 7% in the index, it’ll be 7% in the ETF.

Investors in the ETF get exposure to the 100 companies without buying 100 different shares. Instead of having to buy HSBC, Tesco and the rest separately, they just buy the ETF and that gives the investor access to all 100 companies in a single fund.

Different types of ETFs

Today, ETFs come in a number of different shapes and sizes. This is down to investor demand and advances in technology, which have helped to make ETFs easy to trade at a low cost.

They can be baskets of stocks, bonds or other assets. They can also track indices based on country (like USA stocks, for example), company size (i.e., FTSE 100 companies), or by a particular theme (such as clean energy ETFs).

Some of the most common ETFs you’re likely to come across today include

• Equity ETFs: These track an index of equities. They allow you to target sectors that may be performing especially well, such as banking or tech stocks.
• Bond and fixed-income ETFs: Most financial professionals recommend investing a portion of your portfolio in fixed-income and bond ETFs because these can offer a steady stream of income at a potentially lower risk.
• Commodity ETFs: Commodity ETFs track the price changes of particular commodities, such as gold or oil. These ETFs can help to further diversify your portfolio, although they can be less transparent than index or stock ETFs.
• Currency ETFs: These ETFs invest in a single currency, such as the US dollar, or in a basket of currencies.
• Speciality ETFs: As the demand for ETFs has grown, a variety of funds have emerged to meet specific investment strategies. Two speciality funds you may come across are leveraged funds and inverse funds. Leveraged funds aim to maximise returns by using leverage (i.e. borrowing more money) to invest. Inverse funds profit when the target index goes down. Both types offer potentially high returns, but they can be high risk.
• Sustainable ETFs: This is an area of ETF investment that’s growing, in line with the increasing demand for sustainable investments. Sustainable ETFs largely focus on screening out companies with lower ESG scores, which are used to measure the sustainability of funds. You can learn out more about ESG investing here.

You should always do your research before investing in an ETF, in the same way, that you would before investing in any other type of fund. You can invest in ETFs with an ISA or GIA investment account at CIRCA5000. If you have any questions about investing with us, visit the support page.

Disclaimer

When investing your capital is at risk. You should carefully consider whether opening a CIRCA5000 pension or transferring your old pensions to CIRCA5000 is right for you. Please note that tax rules and reliefs depend on your personal circumstances and might change. CIRCA5000 does not provide financial or tax advice and you are responsible for your own tax reliefs/payments.