What do you do when you’re interested in trading shares alone, but you need more flexibility than an ISA or SIPP provides?
For many investors, the answer is to buy into an exchange-traded fund (ETF). ETFs are the source of a lot of frenzy among both new and established traders because they offer some unique value propositions compared to other funds. All at once, an ETF is beginner-friendly, suitable for long-term investing, and (usually) tax-efficient.
ETFs are certainly behind a renewed interest in the markets, and accessing them is easier than ever thanks to their availability both with full-service advisors and with robo-advisors alike.
Whether you’re looking to save for retirement, build an income, or even try your hand at investing for the first time, ETFs have a lot to offer. But they still come with plenty of risks.
Our guide to ETFs will walk you through everything you need to know about these products and help get you started on the route to building a diverse portfolio.
What is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a combined ‘basket’ of securities. Within the basket, you might find stocks, bonds, commodities or a mix of the above. Because ETFs are traded on the exchanges, each ETF basket has a unique ticker.
At its core, ETFs are a vehicle for buying and selling assets in a single transaction rather than making multiple purchases or sales and paying the individual fees.
Each ETF has a fund provider or owner, who owns the assets, designs the fund, and sells shares in the fund. Investors can buy a share of the fund in the same way they might buy shares of a company (i.e., through a broker). Like stocks, the ETF is traded throughout the day and has different prices.
Unlike stocks, however, when you invest in an ETF, you own a portion of that ETF, but you don’t own the underlying assets.
The goal of an ETF is to track the valuation of the assets and/or securities within the basket. Even still, they are the product of market-determined prices and the long-term return for an ETF won’t necessarily match that of the assets found within.
The above description of an ETF demonstrates the utility of these investments, but it leaves out their true value proposition. An ETF offers investors liquid access to every nook and cranny of the financial markets, both domestically and internationally. They offer opportunities for investors of all backgrounds to build portfolios that are as dynamic and diverse as the likes of Warren Buffet — not really, but the premise is the same. What’s more, ETFs are highly transparent. Both the holdings and the strategy make it far more simple to determine the risk and reward for each product.
Investing in an ETF is like enjoying the features of a mutual fund with the features of trading individual stocks and shares. And it all comes at a significantly lower cost than both those opportunities.
What’s the Difference Between ETFs vs. Mutual Funds?
What’s the difference between an ETF and a mutual fund? After all, both are funds that feature a basket of single or mixed assets.
The biggest difference between ETFs and mutual funds is the management style of the fund. ETFs have a passive management structure, and mutual funds are actively managed. The distinction in management styles is why ETFs are almost always less expensive than mutual funds: an ETF’s low management fees reflect the passive style.
Although mutual funds do come with higher fees and they are less tax efficient due to higher turnover as a result of active management, mutual funds remain the most available of the two assets and there are more mutual fund choices than ETFs — at least for now.
What’s the Difference Between ETFs vs. Tracker Funds?
Both ETFs and tracker funds are forms of investment that track a specific index. They also aim to deliver returns that track the same index. However, they are not the same instrument.
The big difference between the two lies in flexibility. Because ETFs are traded on the stock exchange, they can be bought and sold as if you’re buying shares. You get a set price that reflects in the index at the buy and sell point.
Tracker funds, however, have a different structure. They are either an open-ended investment company (OEIC) or a unit trust. They’re priced once a day. In theory, an OEIC tracker fund is simpler to work out than an ETF because the structure is less complex.
How Do ETFs Work?
Understanding how an ETF works is important because it’s what makes them unique.
An ETF is traded on the stock exchange just as a stock is. However, their addition to the market is not through an initial public offering. Instead, they use a creation/redemption process that creates a continuous process for ETF shares.
Let’s walk through it:
You want to put money into an ETF, so you place an order with your brokerage account and your broker buys the shares from an investor who is selling. You then have shares of the ETF in your account: it’s the same option as buying stock.
Your ETF fund manager, however, isn’t involved in the process. They won’t necessarily even notice. The shares don’t change value, they just transfer.
To get an ETF on the market, it needs to be initiated by a specific group of investors, typically large broker/dealers, with authorisation to create and redeem new ETF shares. The group, who are known as the “authorized participants,” can then create new shares in conjunction with the ETF manager.
Authorised participants have responsibilities that are above and beyond what’s expected of mutual fund investors. When an ETF manager publishes the daily list of securities it wants to place in the fund (the daily creation basket), the AP must go into the market to buy stocks at the right percentages to create the new shares. The basket of securities are delivered to the ETF manager, who then exchanges them for equal value in shares of the ETF (hence, investors never hold the assets).
These blocks of transactions are “creation units” that amount to 50,000 shares (with some exceptions).
The same thing can happen in the reverse if the AP wants to sell a block of ETF shares back.
Why is this so important? The creation/redemption process keeps the price settled in close range around the net asset value (NAV), which is the value of each share’s portion of the underlying assets at the end of trading. It’s what makes ETFs transparent and somewhat predictable.
The History of ETFs
ETFs are an increasingly popular way to invest, both for individuals and institutions. However, they’re still in their infancy compared to stocks and bonds. They’re even young compared to the concept of index investing as a whole. Even mutual funds date back to 1975.
In the 1990s, ETFs came about as a way to invest in index funds but without requiring active management. Active management was out of reach for the general public, and tools like mutual funds were and remain limited to those with the resources to invest significant amounts at once without the need to touch it again.
Passive management became a new obsession because it could unlock billions in investments from people otherwise locked out of the market.
What is Passive Investing?
Passive investing is a strategy often referred to as a “buy-and-hold” portfolio. It’s designed for long-term horizons with as little trading as necessary in order to maximise returns.
How could passive investing improve long-term returns?
Passive investors don’t look to make overnight windfalls based on market timing or short-term fluctuations. Instead of trying to play the market or out maneuver it, the strategy tries to match its performance, which reduces risk.
ETFs and other indexed funds fit into the passive investing strategy because they are funds made up of diverse portfolios. Even if one stock’s performance suffers, it doesn’t tank the entire fund. There’s a balance offered by the diversity that insulates the ETF from huge price swings.
Why is Passive Investing So Popular?
Passive investing and ETFs, in particular, have become incredibly popular since the crash of 2008. Between 2009 and 2019, investors sunk more than $3.5tn in new cash into ETFs. Thomson Reuters says the ETF market is growing by almost 30% each year with no signs of slowing down.
Why is passive investing so popular?
Experts say that the success of passive investments comes down to the fees. ETFs are both cost- and tax-efficient compared to actively managed investments. However, the attraction isn’t just in what ETFs lack.
There’s increasingly less faith in active management, and it’s not just public sentiment. In 2018, data showed that when pension schemes used active trading, they only beat the market by 16p per year for every £100 invested. In the United States, active fund managers missed the S&P 500 for nine consecutive years (between 2009 and 2018.) Part of their failure to deliver returns is the product of the high fees associated with active investing.
Does Passive Investing Come with Any Concerns?
Passive investing first took a foothold in the late 1980s and early 1990s, but its popularity is still growing to an extent that it’s impacting the market in general, thanks in part to an increasing lack of faith in active fund managers’ ability to beat the markets.
In 2019, the United States Federal Reserve reported that the increasing shift from actively managed funds to passive trading was exposing weaknesses in the structure of the financial system. As passive investing continues to gain steam, it seems to be increasing certain risks while mitigating others.
For example, passive strategies may have had the impact of increasing market volatility to the effect that there’s evidence leveraged ETFs in particular “likely contributed to stock market volatility during the financial crisis.”
Another issue stems from the popularity of passive investing in general, particularly as large asset managers use passive funds strategically. For example, Vanguard accounted for almost 25% of the ETF market at the end of 2018. If Vanguard made a strange decision or went through a crisis (such as a cybersecurity crisis), it could cause a huge disruption to the market generally.
However, the Fed researchers also found that passive investing is good in the sense that the long-term investment horizon decreased liquidity.
Who Should Buy ETFs?
Who benefits from buying ETFs? The answer is everyone can enjoy the benefits these investment vehicles provide.
It doesn’t matter whether you have a mature portfolio or you’re just starting out. There are few reasons not to invest.
However, ETFs are particularly well suited to young or new investors with small amounts to invest. They’re the best way to build a diverse and less volatile portfolio without investing huge amounts of your liquid assets into the market. They also cost less, which is ideal for younger investors looking to save over the long-term. Plus, they’re more transparent, which makes them better for those who are acquainting themselves with investing for the first time.
The only exceptions tend to be for those who want to invest but who are either looking for short-term gains exclusively or those who can’t commit to leaving their money in the market for upwards of five years.
What Are the Advantages of Using ETFs?
ETFs have a long list of benefits over stocks and even over traditional funds. However, most advantages fall within four categories:
- Risk management
- Lower costs
- Tax benefits
- Liquidity and flexibility
As an investor with an eye on the long-term horizon, you know that you need a diverse portfolio to weather storms. However, building diversity through traditional investment types is tough, and you might not have access to the kind of securities you’re interested in.
ETFs offer diversity and risk management because they give you exposure to most market segments. You have access to every major asset class, commodity, and even currency through ETFs.
One thing that’s not inherent in trading is transparency. Traditional asset management rarely focused on sharing both portfolio holdings and strategy. Mutual funds and hedge funds have minimal reporting requirements, and investors may not know if fund managers veer out of their lane (i.e., “style drift”) until months after the changes impact their investments.
ETF providers, however, are more likely to provide a far more constructive outlook on their portfolio. Many share their entire portfolios online, and they update them regularly. Though, this wasn’t always common practice for companies like Vanguard, which updated its holdings monthly.
For new investors, ETFs are also easier to figure out. An ETF will usually name the index it tracks in its name, which gives investors a better idea of what they’re looking at from the outset rather than requiring a deep dive into what may (or may not) be in the portfolio. Again, there are exceptions, but transparency tends to be the rule.
Even the price changes during the day are more transparent. ETF issuers work with third parties to generate and then publish the estimate of the value of an ETF based on the day’s creation basket. The value is updated every 15 seconds and is called the “intraday indicative value” or “indication of portfolio value.” As an investor, you can use the updated quote to determine whether to buy or sell.
If you ask a seasoned investor why they own ETFs, they will tell you: you get long-term growth at a very low cost. When you combine the amount of opportunities with investment with an expense ratio routinely below 1%, you’re bound to create a stir.
ETFs aren’t free. Every managed fund includes an operating cost that ranges from management fees, administrative expenses, distribution, and custody costs.
However, the operation costs found in ETFs are streamlined in comparison to other funds, like mutual funds. For example, fund managers don’t have to field questions from thousands of investors, which saves huge amounts of money. Record keeping and distribution costs are also huge for mutual funds, and the costs aren’t required in a world where you can’t interact with the fund company. Plus, unlike mutual funds, they aren’t actively managed, so the day-to-day costs are lower.
Low costs are good news: when you have a lower cost upfront, you can expect a higher return. You can benefit from that no matter what kind of portfolio you have or what your experience is.
ETFs are more tax efficient than mutual funds by their very nature. The structure of an ETF helps save on potential capital gains tax. Unlike with mutual funds, you only pay capital gains when you sell your stake in the ETF.
If you invest in a mutual fund, you pay capital gains throughout the life of your investment.
Liquidity and Flexibility
The liquidity and flexibility of ETFs are a huge advantage because you can buy and sell on secondary markets throughout the day. Just as you can short or option a stock, so too can you do the same with an ETF.
Are There Disadvantages of Investing in ETFs?
All financial investments involve an inherent amount of risk. ETFs come with several disadvantages that every investor must acknowledge before buying in.
First, it’s important to remember that investment risk concentrates itself in the specifics: it impacts a specific sector, company, country, or currency. As a result, funds are very sensitive to events. Minimising risk usually requires a broad ETF that tracks an index that covers a huge section of the market. Even still, it’s important to remember that volatility still impacts ETFs no matter what.
A second disadvantage is a lack of liquidity. When an asset is liquid, it means that there’s enough interest in it that you can buy and sell without disrupting the price. If an ETF has few investors, it can be hard to sell and can even collapse. You can spot illiquid ETFs if they have a large spread between the bid and ask.
Finally, you need to be aware of how your chosen ETF distributes capital gains. In an ideal world, your ETF will reinvest those gains on your behalf, but you may find that an ETF tries to distribute them thereby leaving you with either a tax liability or the need to spend more on the fund by asking the broker to buy more shares to re-invest manually.
How Are ETFs Structured?
ETFs are traded in the same way as stocks are: the manager can buy and sell throughout the day as they see fit. But within the ETF category are two different structures: physical and synthetic ETFs.
A physical ETF is the traditional form of an ETF. When you invest in a physical ETF, you’re investing in a fund that actually holds the assets and securities that form the basis for the ETF’s value. In other words, the ETF fund manager actually buys and holds either all or a representative subset of the assets and securities within the index. The fund then rebalances whenever the index does the same.
The second ETF, the synthetic ETF, only reached European markets in 2001. Synthetic ETFs exchange the physical trading in favour of derivatives (or a contract between two parties). The fund manager does not purchase the asset or security. Most synthetic ETFs instead use swaps as the primary derivative and agreement between the ETF and the counterparty, which is liable for paying out any returns generated by the underlying asset.
As you can imagine, a synthetic ETF is far more complicated than a physical ETF. It also includes two different types: unfunded and funded. In an unfunded synthetic ETF, the ETF uses the basket of liquid assets as collateral with the investment bank (or another counterparty). A funded structure sees the basket go to an independent custodian rather than the bank.
There’s a raging debate about the value of physical ETFs vs. synthetic ETFs. Synthetic ETFs took a huge hit in popularity because they come with substantial risks in comparison to some physical ETFs.
How Do Physical ETFs Compare with Synthetic ETFs?
Physical ETFs are easier to understand for those new to investing, and they come with fewer risks compared to synthetic ETFs. They are more transparent, but you may be limited to only certain markets.
A synthetic ETF allows you to get into markets that you may not otherwise have access to, and it does a better job of tracking the true valuation of the basket of assets against the index. The use of more complex methodologies as well as derivatives mean there’s less variance in the fluctuation of the daily movements.
Some investors believe that the access to U.S> equity benchmarks gives the synthetic ETF a true advantage over the physical ETF. Typically, you would be subject to a withholding tax as a foreign investor. However, when you’re operating using swaps, you aren’t required to pay those withholding taxes on dividends, which would otherwise be as much as 30%.
Synthetic ETFs also tend to be less expensive because they have lower operational costs.
However, you should be aware that synthetic ETFs come with counterparty risks (or default risk). A counterparty risk means that you must rely on the counterparty (who compensates the fund) to honour their agreement: if a financial institution can’t pay the index return, then you could be out of luck. After all, you don’t own any of the assets.
Using collateral helps protect investors against counterparty defaults. Today, providers tend to over-collateralise to make up for the risk: it’s not uncommon to see a collateral of 110%. Some providers of synthetic ETFs also use a multiple swap-counterparty model, which means you’ll have more than one counterparty involved.
What Asset Classes Are Available?
You can buy ETFs in most corners of the market, and that’s reflected in the asset classes and categories available to you. You can buy:
- Equity ETFs
- Fixed-Income ETFs
- Commodity ETFs
- Currency ETFs
- Alternative ETFs
- Leveraged ETFs
- Inverse ETFs
- Multi-Asset ETFs
How Should You Buy an ETF?
In the UK, you can invest in ETFs in one of a number of ways.
If you’re young and you are beginning to contribute to retirement accounts, then you should consider investing in ETFs through either a stocks and shares ISA or a SIPP. These two accounts (should) offer access to many different ETFs, and they are the type of accounts that cater to the goals of an ETF investment: sustainable, long-term growth.
Starting with an ISA or SIPP is important because these allow you to make the most of your tax-free savings and investing. Unless you have an exceptional circumstance, you should be maximising those contributions first.
The amount you can currently invest in an ISA or a collection of ISAs is currently £20,000 per annum.
The amount you can invest in a SIPP is 100% of your annual earnings with a maximum of £40,000.
Once you reach your tax-free contribution limits, you can then invest in ETFs through a normal investment account or dealing account offered by a broker.
Get Started: How to Choose an ETF
As with all investments, there’s no one-size-fits-all mechanism available to you to suggest the right ETF.
Although ETFs have the distinct benefits of being low-risk, passive investments, choosing the right ETF still has multiple components. You won’t be buying or selling individual assets, but the assets in the bundle still need to be suitable for your goals.
Before diving in, it’s worth noting that the vast majority of ETFs in the UK come from the same few providers. iShares is currently the largest provider of ETFs in the UK.
How Do Investment Goals Play a Role in Your Choice?
Like any investment decision, you need to start your research by first identifying your goal for the purchase. The rules of thumb differ for ETFs compared to other assets because of the number of options available to you and the long-term scope of the investment type.
Like most investments, you start your selection by identifying your primary goal (long-term wealth, income generation, short-term market movements) and your risk appetite.
If you already have a portfolio, start by asking yourself the following questions:
- Why do you want to invest in ETFs?
- Is your goal to diversify your portfolio?
- How do you want to diversify your portfolio?
- Are you looking to lower your costs?
- How much are you considering investing?
- When do you hope for a return?
- What can you invest knowing you should leave money in an ETF for at least 5 years?
Your goal is to find an ETF that tracks an index related to your investment strategy and offers a cost that suits your goals.
How to Choose the Right Index for Your Goals
With your risk appetite in mind, your first stop on your journey is to choose the correct index, one that matches your goals. It’s the index, not the investment bundle, that defines the proposition offered by ETFs.
Unfortunately, there are 1.5 million indices to choose from. Expect to spend the majority of time allocated to researching your preferred index and then looking at the ETFs themselves. Although there are a huge number of ETFs out there, the vast majority are overseen by just a handful of providers, like iShares, Vanguard, and Blackrock.
When starting the search for your index, a good rule of thumb is to follow an index that covers as much of your target market as possible.
The FTSE All-Share index is a good example. The index tracks a whopping 98% of the UK stock market, which gives you very broad access to investable equities in the UK markets.
As you can imagine, broad market indices represent the best diversification opportunities. When an index focuses on a particular country, industry, or firm, it comes with a greater risk.
If you’re new to indices in the UK, start with these major indices:
- FTSE 100
- FTSE 250
- FTSE 350
- FTSE All Share
- FTSE AIM 50 Index
- FTSE AIM 100 INDEX
- FTSE AIM All-share
Those interested in U.S. products should start with the S&P 500.
What Other Factors Are Involved in Choosing an ETF?
Once you choose your preferred index, you can then decide whether a physical or synthetic ETF best suits your needs.
However, there are still more decisions to make. You’ll need to weigh up:
- Dividend treatment
Your preferences are likely to be as specific as you are, but if you choose the right index in the first place, then you are more likely to find greater success as you work down the list.
How Much Do ETFs Cost?
Your provider deducts fees from your account, and these fees can be vastly different depending on the provider. While ETFs are less expensive than mutual funds, not all ETFs are considered to be ‘cheap.’
The fees associated with ETFs are typically low because ETFs don’t require active management. However, they do still exist. You may pay costs like bid/offer spreads as well as brokerage fees.
Remember that the cheapest fees are almost always for synthetic ETFs, but they also come with the associated risks.
Who Are the Most Popular ETF Brokers?
The popularity of ETFs means that many of Britain’s brokers offer these funds to their investor clients.
Some of the biggest brokers include:
What are the Most Popular ETFs?
ETF popularity varies week by week as investors make decisions and new investors enter the market. Even still, there is a list of funds that remain popular choices among investors week-in and week-out.
Remember that popularity doesn’t indicate that the fund is the right choice for you. But by looking at what these funds offer, you can begin to see what makes an attractive investment.
Popular UK ETFs
Buying a UK ETF is the simplest way to invest your money across the UK’s stock market as a whole. The UK Stock Market has 3 major indices and 7 alternative indices.
Some of the most popular UK ETFs include:
- iShares Core FTSE 100 UCITS ETF
- Vanguard FTSE 100 UCITS ETF
- SPDR FTSE UK All Share ETF
- L&G FTSE 100 Super Short Strategy
- Vanguard FTSE 250 (VMID)
- iShares Core S&P 500 (CSPI)
- SPDR S7P UK Dividend Aristocrats (UKDV)
- Lyxor Core Morningstar UK UCITS ETF
- iShares UK Dividend UCITS ETF (IUKD)
Popular U.S. ETFs
The ETF market in the United States is massive. In fact, the five largest ETFs domiciled in the U.S are larger than Europe’s entire ETF offering. What’s more, the U.S. tends to be pioneering in its developments, which can be exciting for keen investors.
However, there are some challenges in buying U.S. ETFs from Europe, including the UK as long as EU rules apply. European investment regulations changed at the beginning of 2018, and because U.S. ETFs serve the U.S. market, they largely didn’t comply as Europeans aren’t a priority investor market.
If you’re a UK resident and you want to partake, then you need to find a broker who will sell you U.S. ETFs. Even Vanguard won’t sell you its U.S. products.
However, this is subject to change in 2021 when European rules no longer apply to UK investors.
In the U.S., the most popular ETFs by trading volume include:
- SPDR S&P 500 ETF
- iShares MSCI Emerging Markets ETF
- Financial Select Sector SPDR Fund
- VanEck Vectors Gold Miners ETF
- VelocityShares 3x Long Crude Oil ETN
- iPath Series B S&P 500 VIX Short-Term Futures ETN
- Invesco WQQQ
- United States Oil Fund
- ProShares UltraPro SHort QQQ
- iShares MSCI EAFE ETF
Guide to ETFs Summary
ETFs are a relatively new investment vehicle that offer investors of all types unique benefits not found in traditional funds or in individual assets and equities. The craze surrounding ETFs comes from the transparency with which they operate, the lower costs they generate, and the flexibility they offer.
Although passive investing is a low-maintenance style of training, choosing the right ETF isn’t as simple as throwing a dart and selecting whatever product it lands on. You still need to find an ETF that matches your goals, and a huge part of that process involves demands choosing the right index.
Ultimately, ETFs open up the global markets to single investors in ways that will inevitably improve your portfolio, whether you’ve been trading for years or you’re just getting started. Remember that ETFs give you access not only to British markets but to U.S, European, Asian, and emerging markets, too. So it’s worth asking your current broker about what ETFs are available and which of those products will suit your portfolio as it stands now.
Peter Field – CFA
Editor in Chief
Peter uses his many years of experience to oversee the reviews and guides published on InvestingReviews.co.uk
When not at his desk, Peter is training for his next triathlon and trying to be a great dad and husband.