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What is an ETF and how can I invest?

Exchange-traded funds (ETFs) are a type of investment vehicle that track the performance of a broad index, sub-sector of that index, or an industry sector. Read our in-depth article about investing in ETFs, from management style to costs, and how they differ from index funds and mutual funds.

What are exchange-traded funds?

Exchange traded funds are investment funds that hold a collection of underlying assets, such as shares, commodities and bonds. ETF portfolios are held by corporations which issue shares (a portion of ownership) of the fund. These shares give investors exposure to the underlying assets. For most ETFs, the strategy is passive style management.

ETFs are quoted on exchanges and can be bought and sold like any other share or stock. The fund’s share price very closely follows the price of the underlying assets. If they wish, investors can adopt buy and hold strategies with ETFs for potential long-term growth. ETFs are transparent, as all fund holdings are declared on a daily basis.

Depending on regulations, the legal structure of the fund will usually be an investment company or corporation. Varying structures often exist side by side in the same jurisdiction.

Passive vs active ETF

There are two different management styles of an exchange-traded fund, which are explained below.

  • Passive management: this is the most common type of ETF management. Passive ETFs typically track an existing index (such as the FTSE 100 or S&P 500), and the portfolio is usually updated on a quarterly or monthly basis to reflect any changes made to the index upon which it’s based. These cannot be modified internally by a fund manager as they aim to reflect the market or industry as a whole.

  • Active management: active ETFs involve an investment or hedge fund manager actively managing a portfolio of securities. This means that they can change and remove securities within the fund according to changing market conditions, selecting the ones they think will perform the best. This type of management is less common, but some investors may see it as more profitable, as you can avoid poorer performing stocks.

How do ETFs work?

Creation and redemption

Fund shares are created and redeemed by authorised participants (APs) – usually banks or other financial institutions. These institutions buy the underlying assets to create the portfolio. Once the portfolio is ready, the assets are turned over to the fund. The fund then exchanges the portfolio for newly created ETF shares. APs can also redeem shares when they return them to the fund in exchange for the underlying assets.

APs have a lot of buying power, as ETF shares are usually issued in large blocks (a block trade). Due to the capital needed, individual investors are unlikely to be able to finance the operation. This mechanism of creation and redemption is essential to keep the price of the fund in line with the real value of the underlying assets.

The capability of APs to create and redeem shares means that if the price of the fund deviates from its fair value, the AP can step in and take advantage of the price differential. For example, on occasion, the fund may see buyers push the price of its shares above the aggregate value of its underlying assets. If this happens, at some point it may be profitable for the AP to buy the underlying assets and sell shares of the ETF in exchange for shares that are valued higher. The creation of new shares adds to the supply of ETF shares and brings the price of these shares in line with the underlying value.

The same can happen if the share price of the ETF falls below the aggregate value of its assets. At some point, it may be profitable for an AP to buy the ETF shares and redeem them for the underlying assets at a discount to the current market price. This functionality helps to make sure that the price of the ETF’s shares does not deviate much from the actual market value of its assets.

Taxation

ETFs may be subject to different tax treatment than other fund structures, depending on jurisdiction. In the UK, it is important to check that the ETF has either a reporting or investor status. 75% of funds in the UK have this status. This status is vital because any gains made from ETFs with this status are subject to capital gains tax rather than income tax. Capital gains tax varies from 18% to 28%, while income tax can be as high as 50%.

One should also remember that if the ETF is not in the same jurisdiction as where it is being traded, the ETF may apply a withholding tax. Sometimes this tax rate can be as high as 30%.

ETF expense ratio

An expense ratio is an annual fee paid to fund managers by holders of an exchange-traded fund, which is expressed in the form of a percentage. It is essentially the cost of operating and managing the fund. As passive ETFs track existing stock indices, these tend to have a lower expense ratio, whereas active ETFs will typically have a higher expense ratio as there is more management.

ETF expense ratios can vary between 0.5% and 1.0%. According to Morningstar, the average ETF in 2021 carries an expense ratio of 0.41%, meaning that for every $10,000 you invest, you would pay around $41 per year in operational fees.

Distributing vs accumulating ETFs

It can be difficult to know which type of exchange-traded fund to choose between a distributing and accumulating one. Here is the difference between the two:

  • Distributing: a distributing ETF pays out all dividends and interest earned on the position to the shareholder. This is usually carried out on a monthly or quarterly basis, similar to when you are investing in stocks​.

  • Accumulating: an accumulating ETF reinvests this income back into the fund so that the investor can earn further interest in the future. Even though the investor keeps the same number of shares, they are ultimately worth more as returns will be compounded.

Some investors favour accumulating ETFs as they believe it will provide better investment returns in the long run. However, if you want to generate regular income from your ETF portfolio, you may decide that distributing ETFs are better suited for you. This income can be withdrawn from your account balance and spent straight away.

What are some ETF types to invest in?

ETFs based on sectors/industries

These types of ETFs track companies belonging to the same stock market sector or industry. They follow trending themes and generally have high liquidity. Examples include:

  • Financials: Financial Select Sector SPDR Fund

  • ESG/ethical: Global X Conscious Companies ETF

  • Artificial intelligence (AI): ARK Autonomous Technology & Robotics ETF

Stock index ETFs

Index ETFs track the performance of international benchmark indices for a particular country or continent, such as the US, UK or Europe. Examples include:

  • FTSE 100: Vanguard FTSE 100 UCITS ETF

  • S&P 500: iShares Core S&P 500 ETF

  • Nasdaq 100: Invesco QQQ ETF

Commodities

Commodity ETFs usually take their prices from futures contracts for a particular raw material, or they can be commodity-linked ETFs, which track the performance of commodity-related companies. Examples include:

  • Oil: United States Oil Fund

  • Gold: SDPR Gold Shares

  • Water: First Trust Water ETF

Geographical ETFs

These types of ETFs track assets in a specific geographical region, including emerging markets such as Brazil, Russia, and China, as well as international, or for a specific country. Examples include:

  • Emerging markets: iShares Core MSCI Emerging Markets ETF

  • Global: Vanguard Total International Stock ETF

  • Europe: SPDR Portfolio Europe ETF

ETF vs mutual fund: what’s the difference?

Exchange-traded funds offer cost efficiency because of the way the fund is set up. APs bear the costs involved in buying the underlying assets, whereas a mutual fund will pay fees to the bank or financial institution every time they buy or sell assets. The AP then profits from the bid-offer spread of the quoted shares.

Depending on jurisdiction, ETFs may offer a more tax-efficient alternative to conventional mutual funds. The US provides some tax benefits when investing in ETFs, compared to traditional funds, but the same is not true in all jurisdictions.

Traditional funds tend to be more broad-based when it comes to the assets it contains in order to satisfy diversification of risk. This is compared to more specific ETF assets. With ETFs, one can gain exposure to a portfolio as specific as a smartphone index or real estate index​​. The extensive range of ETFs allows for more control in one’s diversification strategies. High minimum investments are often required to enter mutual funds, whereas ETFs do not have such limitations. This means that even a small portfolio can be diversified at an efficient cost.

ETF vs index fund: what’s the difference?

Passive ETFs are often referred to as index funds, as the two products share many similarities. An index fund can come in the form of a mutual fund or exchange-traded fund. However, whereas mutual funds are bought and sold at a set price each trading day, ETFs trade like a share on the stock market.

The main differences between ETFs and index funds include fees and expenses, such as commissions; the way they are taxed; the liquidity of assets; and the minimum investment you are required to pay to kick off the trade.

How to invest in ETFs

In order to invest in ETFs, you need to open an account with a broker that allows you to buy and sell the assets. Then, you will need to analyse some of the following details to find the right ETF for you:

  1. Choose the type, size, structure, and management style. Larger and more liquid funds tend to be easier to manage but these are not preferred by everyone.
  2. Check the expense ratio and other operational fees. You could even look for high-dividend ETFs if you want to maximise your return potential.
  3. Calculate the ETF’s past performance to gauge potential returns in the future. Note that past performance is not a reliable indicator of future results.

What are leveraged ETFs?

A leveraged ETF is a form of exchange-traded fund that uses debt to multiply the returns of an underlying index. Whereas a traditional ETF tracks securities using a 1:1 ratio, a leveraged ETF may choose a 2:1 or 3:1 ratio instead. The more leverage the fund employs, the higher the potential is to magnify gains if the index increases in value. However, this also works the other way around and could end up in 2% or 3% increased losses if the ETF underperforms.

Investors can also hedge a specific sector of a broad index ETF. For example, if one is holding an ETF tracking the S&P 500 but is concerned that a particular sector within the index will perform poorly, they could find an ETF that tracks the inverse return of that sub-sector. Buying shares in that ETF could hedge a fall in price of the original ETF.

Advantages of exchange-traded funds

  • ETFs are a low-cost investment choice. Some ETF fees are as low as 0.3%, compared to the average 1.4% paid to mutual funds. One will of course still pay a fee to their broker to buy an ETF, but this fee is usually similar to the fees charged to buy and sell mutual funds. The difference in fund fees when implementing a buy and hold portfolio can be substantial, especially when the investment horizon is long term. Saving 1% per year over a 20-year investment horizon has its benefits.

  • ETFs are also easy to enter and exit. The funds are traded over an exchange and shares can be bought and sold with relative ease, as compared to the redemption schedules of some mutual funds. Ease of execution, combined with a vast sample of asset classes and diverse investing strategies, offers a lot of flexibility.

  • Assets are usually liquid and transparent, and fund holdings are declared daily. This means that investors will not have to forego a significant discount to the fair NAV when exiting a market. At the same time, when demand is high, one would not have to pay a large premium to gain access to the fund's assets.

  • ETFs also offer easy access to interest-rate securities. Exposure​​ can also be gained from mutual funds, but when interest rates are on the rise, fund performance begins to suffer. Recently, institutions have been offering funds that have negative duration. In simple terms, this means that these funds gain in price when interest rates are on the rise. Some of the most popular bonds to invest in​​ are influenced by interest rates and therefore, the value of their ETF can increase dramatically.

What are the risks of ETFs?

While ETFs have many advantages, traders should also be aware of any risks associated.

  • Traders should consider that when investing in exchange-traded funds, in some countries, they may be limited to large-cap stocks​​ only, given the narrow range of stocks in the market index. Being exposed to only a limited range of stocks may mean an investor loses out on potential growth opportunities.

  • The benefits of investing in ETFs also depend on what type of trader you are. Intra-day trading opportunities created by ETFs could benefit short-term traders but will be less suitable to a trader looking to profit in the long-term.

  • Finally, exchange-traded funds can also be affected by market liquidity. It is important to assess the spread between the bid and the ask price. If there is a large spread, this can be a sign of an illiquid investment.

A guide to exchange-traded funds

In this eBook, we discuss the difference between ETFs and mutual funds, provide exclusive expert interviews, and give a list of ETFs to watch.

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Summary

Exchange-traded funds offer a comparatively cheaper way to invest in a myriad of assets and indices. They offer transparent pricing, where the NAV of ETFs is calculated on a daily basis and holdings are public and published daily. ETFs are also easy to enter and exit as the shares are quoted and traded on exchanges. All these factors contribute to making ETFs an efficient diversification vehicle. The diversification factor offered from the wide range of investment targets runs down to smaller portfolios, which are outsized by many mutual funds.

FAQs

Are ETFs a good investment?

ETFs are a popular investment for both passive and active investors, as they provide exposure to multiple securities using a single position. However, all investments carry risks and ETFs are no exception; if one constituent underperforms in the market, then this will drag on the overall performance of the ETF. Read how to combat risks in trading with our complete guide.

Are exchange-traded funds safer than stocks?

Exchange-traded funds can be viewed as safer than trading on an individual stock, as your risk is spread out across several instruments instead of just one, so you’re not relying on a single asset. However, ETFs can also experience volatility, gapping or slippage in the same way that stocks do. Read about our order types, a collection of risk-management tools that can help to control these factors in trading.

Do ETFs pay dividends?

Exchange-traded funds pay a full dividend to investors on a quarterly basis that comes from the constituent stocks within the fund. Some notably high-yielding dividend ETFs include the Global X SuperDividend ETF, iShares Emerging Markets Dividend ETF and SPDR S&P Dividend ETF. Check our article on high dividend ETFs for more information.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

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