What Are ETFs and How Do They Work?

Exchange-Traded Funds (ETFs) are a key investment product in today’s financial markets. They provide individual investors, pension funds, advisers, wealth managers, and institutions with straightforward access to a broad range of investments through a single product.

Unlike purchasing a single company share, an ETF is a fund that typically holds a variety of assets, including shares, bonds, commodities, or a combination of investments. ETFs trade on stock exchanges like ordinary shares, allowing investors to buy and sell them during market hours through brokers or investment platforms.

Investors use ETFs for long-term growth, diversification, income, and targeted market or sector exposure. However, ETFs carry risks. To make informed decisions, investors should understand the fund’s holdings, tracking method, structure, issuer, costs, and associated risks.

What Is an ETF?

ETF stands for Exchange-Traded Fund.

The name describes the product: Exchange-Traded means the fund is bought and sold on a stock exchange, like a regular share.

A fund means it pools money from many investors to invest in a portfolio of assets.

For example, an ETF may hold shares in hundreds of companies. Instead of buying each company separately, an investor can buy one ETF to gain exposure to the entire group.

A simple example is an ETF that tracks the S&P 500. The S&P 500 is an index made up of 500 large companies listed in the United States. An ETF tracking this index aims to follow its performance. By buying one unit of that ETF, an investor gets exposure to a broad part of the US stock market. This is one reason ETFs are popular: they make diversification easier.

How Does an ETF Work?

An ETF creates a portfolio designed to meet a specific investment objective.

Most ETFs track a benchmark, which serves as a reference point. This benchmark could be a stock or bond index, a commodity price, or a specific sector.

For example:

An ETF tracking the FTSE 100 aims to follow the performance of the 100 largest companies listed on the London Stock Exchange.

An ETF tracking the MSCI World Index aims to replicate the performance of large- and medium-sized companies across developed markets.

A gold ETF may aim to follow the price of gold.

A technology ETF may hold shares in technology companies.

When investors buy an ETF, they do not select each investment. Instead, they gain exposure to the fund’s overall strategy. If the ETF’s assets increase in value, its price usually rises. If the assets decrease, the price typically falls.

Who Issues ETFs?

Asset management companies create and manage ETFs. They design the ETF, determine its benchmark, manage the fund structure, publish required documents, and charge fees.

Some of the largest ETF issuers in the world include:

• BlackRock iShares

• Vanguard

• State Street SPDR

• Invesco

• Amundi

• DWS Xtrackers

• Legal & General Investment Management

• HSBC Asset Management

The ETF issuer operates the fund, but the assets are typically held separately by a custodian. This separation ensures the fund’s assets are not mixed with the issuer’s business assets. Investors should review the ETF provider, fund documents, factsheet, and legal structure before investing.

What Can ETFs Invest In?

ETFs can provide exposure to a wide range of investments.

The most common ETF categories include:

Equity ETFs

These hold company shares. They may track broad stock markets, countries, regions, or sectors.

Bond ETFs

These hold government bonds, corporate bonds, or a mix of fixed-income investments.

Commodity ETFs

These may track commodities such as gold, silver, oil, or agricultural products.

Sector ETFs

These focus on industries such as technology, healthcare, energy, financial services, or consumer goods.

Thematic ETFs

These focus on long-term themes such as cybersecurity, clean energy, artificial intelligence, robotics, or ageing populations.

Regional ETFs

These invest in specific geographic areas, such as the US, Europe, Japan, emerging markets, or global markets.

Multi-asset ETFs

These combine different asset classes, such as equities and bonds, into a single product.

The risk level depends on the ETF’s holdings. For example, a global equity ETF differs significantly from a leveraged oil ETF or a focused technology ETF.

ETF vs Individual Shares

A simple way to understand ETFs is to compare them with individual shares.

When an investor buys a share of a company, the results depend on that company’s performance. If the company does well, the investment may rise; if not, it may fall sharply.

For example, buying only Apple shares exposes the investor mainly to Apple’s performance, including its earnings, products, management, valuation, competition, and broader market conditions.

An ETF spreads investment across multiple holdings. For example, a global equity ETF may hold shares in hundreds or thousands of companies across various countries and sectors. This reduces company-specific risk, as the investor is not dependent on a single business.

However, diversification does not eliminate all risk. If the overall stock market declines, a diversified ETF can still lose value.

Physical ETFs and Synthetic ETFs

ETFs can be structured in several ways. Two key types are physical ETFs and synthetic ETFs.

A physical ETF buys the actual assets it is intended to track.

For example, a physical FTSE 100 ETF may hold shares in the companies included in the FTSE 100 index. A physical gold ETC may hold physical gold or use a structure linked to stored gold.

A synthetic ETF may not hold the exact assets in the index. Instead, it uses financial contracts, usually swaps, to replicate the index’s return.

Synthetic ETFs can be useful where physical replication is difficult, expensive, or inefficient. However, they introduce counterparty risk, meaning the investor is partially exposed to the financial institution that provides the swap.

Physical does not always mean safe, and synthetic does not always mean risky. Investors should understand the difference.

Accumulating and Distributing ETFs

ETFs can treat income in two main ways.

A distributing ETF pays income directly to investors. This income may come from dividends, bond interest, or other income generated by the assets inside the fund.

An accumulating ETF automatically reinvests income within the fund. Instead of receiving cash payments, the investor benefits as the fund’s value may grow over time through reinvestment.

The choice depends on the investor’s goals. Investors who want regular income may prefer ETFs that distribute income. Investors focused on long-term compounding may prefer accumulating ETFs.

This distinction matters because two ETFs can track the same index but handle income differently.

How Investors Can Make Money from ETFs

There are two main ways investors can make money from ETFs.

The first is capital growth, which occurs when the ETF price increases. For example, if an investor buys an ETF at £100 and sells at £120, the £20 difference is a capital gain before costs or taxes.

The second is income. If the ETF holds dividend-paying shares or interest-paying bonds, it may receive income that can be paid out to investors or reinvested, depending on the ETF's type.

For long-term investors, combining capital growth and reinvested income can be powerful. Reinvesting income enables compounding, where returns generate further returns over time. However, returns are not guaranteed. ETF prices fluctuate with market conditions.

What Are the Costs of ETFs?

ETFs are generally lower-cost than many actively managed funds, but they are not free.

The main cost is the ongoing charge, also known as the OCF or expense ratio. This is the annual fee charged by the fund provider. If an ETF has an ongoing charge of 0.20%, this means the annual fund cost is £2 for every £1,000 invested, before other costs are considered.

Other possible costs include:

• Broker platform fees

• Trading commission

• Bid-ask spread

• Currency conversion fees

• Fund transaction costs

• Tax costs depend on the investor’s country and account type.

The bid-ask spread is important. It is the difference between the ETF’s buy and sell prices. Highly liquid ETFs usually have tighter spreads, while smaller or specialised ETFs may have wider spreads. A low fee is helpful, but investors should also consider factors such as quality, fund size, liquidity, structure, currency, and risk.

What Is Tracking Error?

Most ETFs aim to track a benchmark, but their performance may not exactly match it.

This difference is called tracking error. Tracking error can result from fees, trading costs, tax treatment, cash holdings, timing differences, or imperfect replication.

For example, if an index returns 8% in one year and the ETF returns 7.7%, the difference may be partly due to fees and tracking differences. A small tracking difference is normal. However, if an ETF consistently underperforms its benchmark, investors should investigate the cause.

Are ETFs Safe?

ETFs can be straightforward, but they are not automatically safe.

The risk depends on what the ETF holds.

A broad global equity ETF may be diversified across many companies and countries, but it can still fall during a global market downturn.

A bond ETF may appear conservative, but it can lose value when interest rates rise or when credit risk increases.

A sector ETF may perform well when that sector is popular, but it can also suffer large losses if the sector becomes overvalued or faces pressure.

A leveraged ETF can be very risky because it uses financial techniques to magnify daily returns.

ETF structure is only one aspect of analysis. The underlying assets are more important.

Main Risks of ETFs

ETFs carry several risks.

Market risk

The value of the ETF can fall if the market or asset class it tracks falls.

Currency risk

If the ETF invests in foreign assets, exchange rate movements can affect returns.

Tracking risk

The ETF may not perfectly follow its benchmark.

Liquidity risk

Some ETFs may be harder to trade, especially in stressed market conditions.

Concentration risk

An ETF may appear diversified but still be heavily exposed to a few large companies, sectors, or countries.

Counterparty risk

This is more relevant to synthetic ETFs, where returns depend in part on financial contracts with another institution.

Interest rate risk

This is especially important for bond ETFs. When interest rates rise, bond prices often fall.

Commodity risk

Commodity ETFs can be affected by supply, demand, storage costs, futures contracts, and geopolitical events.

Understanding these risks is essential before investing in ETFs.

Why ETFs Became So Popular

ETFs gained popularity by solving several practical problems for investors.

Before ETFs, building a diversified portfolio was often expensive and complex. Investors had to buy many individual shares or use traditional funds, which typically had higher fees and less flexibility.

ETFs allow investors to access diversified portfolios through a single traded product.

They are popular because they can offer:

• Broad diversification

• Lower costs

• Transparency

• Easy access through brokers

• Exposure to global markets

• Intraday trading

• A wide range of investment choices

Many long-term investors use ETFs as the foundation of their portfolios. A simple portfolio may include one or two broad ETFs, while a more advanced portfolio may combine equity, bond, sector, and regional ETFs.

What Should Investors Check Before Buying an ETF?

Before buying an ETF, investors should review the fund factsheet and key investor documents.

Important points to check include:

1. What index or benchmark does the ETF track?

2. What assets does it hold?

3. Is it physical or synthetic?

4. Is it accumulating or distributing?

5. What is the ongoing charge?

6. What currency is the ETF traded in?

7. What currency are the underlying assets in?

8. How large is the fund?

9. How liquid is the ETF?

10. Does it use leverage?

11. Does it lend securities?

12. What are the main risks?

13. Is it suitable for the investor’s time horizon and risk tolerance?

Many investors mistakenly choose an ETF based only on its name. The name is not enough; actual holdings and structure are more important.

Example: A Global Equity ETF

Suppose an investor wants exposure to global stock markets. One option is to buy shares in many companies across the US, Europe, Japan, and other developed markets, which requires significant research, time, and higher transaction costs.

Another option is to buy a global equity ETF. This ETF may hold hundreds or thousands of companies across various countries and sectors, providing broad exposure through a single product.

However, this does not make the investment risk-free. If global stock markets decline, the ETF will likely fall as well. Many global indices are heavily weighted toward the US market and large technology companies, so even a “global” ETF may not be as balanced as expected. This highlights the importance of reviewing the ETF’s holdings.

ETF, Index Fund, and Mutual Fund: What Is the Difference?

An ETF is similar to an index fund, as both can track a market index.

The main difference is how they are traded.

An ETF trades on a stock exchange throughout the day, with its price changing during market hours.

A traditional index fund or mutual fund is usually bought or sold directly through the provider or platform, with the price calculated once per day after market close.

ETFs offer greater trading flexibility, but investors do not need to trade them frequently. Many use ETFs for long-term investing, despite their intraday trading capability.

Summary

ETFs are important because they make diversified investing accessible. They allow investors to gain exposure to a basket of assets through one product, often at a low cost.

They can be used to invest in broad markets, specific sectors, bonds, commodities, regions, or long-term themes. ETFs may be accumulating or distributing, physical or synthetic, simple or complex.

The main advantage of ETFs is convenience. The main risk is misunderstanding. An ETF may appear simple, but its risk depends on its underlying assets.

Before investing in an ETF, investors should understand:

• What the ETF tracks

• What it holds

• How it is structured

• What it costs

• How liquid it is

• What risks does it carry?

• Whether it matches their investment objective

ETFs can be useful tools, but should be selected carefully. The best ETF is not always the cheapest or most popular, but the one that fits the investor’s strategy, risk tolerance, time horizon, and understanding.

Educational content only. Not financial advice.