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Exchange traded funds (ETFs) are investment funds that hold a collection of underlying assets, such as shares, commodities and bonds. ETF portfolios are held by corporations that 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 long-term growth. Although ETF trading sometimes pays dividends, a majority of those earnings are kept within the fund. Investors are entitled to a portion of the profits, for example through earned interest. ETFs are transparent, as all fund holdings are declared on a daily basis.
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What is an ETF?
ETFs are investment funds thatcan track a broad index, sub-sector of that index or an industry sector, for example financials, commodities or energy stocks. Gold and crude oil ETFs are one example of gaining exposure to underlying commodities, as well as more scarce water ETFs.
The popularity of ETFs has been on the rise since they first appeared. From 2006 to 2017, net issuance of these funds in the US has gone up from $74 billion to $471 billion. In the first quarter of 2016, global assets under management for ETFs amounted to $3 trillion across 64 exchanges in 51 countries globally. 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.
Exchange-traded funds in the UK
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 guarantees 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%. Learn more about these types of corporate actions.
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ETF vs mutual fund
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.
Leveraged ETFs
Rather than buying the funds outright, some brokers offer the chance to trade on ETF prices using leverage, and there are also funds that invest in short positions. So, if a trader is bearish on a specific market or asset, they could buy shares that profit from a fall in price. These funds can be used to hedge long positions already held or to make speculative investments to the downside.
Traders can also hedge a specific sector of a broad index ETF. If one is long an ETF tracking the S&P 500, but 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 would hedge a fall in price of the original ETF.
Open an account to start trading on the underlying price movements of ETF funds. We offer over 1,000 exchange-traded funds on our Next Generation trading platform, including some of the most popular ETFs right now.
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. It is possible to find ETFs that are set up to gain in price when interest rates go up. Some of the most popular bonds to invest in are influenced by interest rates and therefore, the value of their ETF can increase dramatically.
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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 fundscan 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.
How to trade ETFs
- Open a live account. We offer 1,000+ exchange-traded funds on our platform, including popular titles from iShares, Invesco, Vanguard and ARK Invest.
- Choose your derivative product. Learn about the differences between spread betting and CFD trading before opening a position.
- Build an effective risk management strategy. Read about our execution and order types to see how stop-loss and take-profit orders can help to prevent capital loss.
- Read our article on high-dividend ETFs to discover which fund can get you the highest dividend payout.
ETFs vs stocks
ETF trading is often compared to trading other pools of stocks, such as mutual funds. It is possible that the costs associated with trading ETFs might actually be higher. Trading ETFs as opposed to a specific stock however, may include costs like a management fee, which would make costs higher overall. As when trading individual stocks, you will also have to pay a commission charge on trades. Learn more about our trading costs before opening a position to spread bet or trade CFDs on our range of exchange-traded funds. You can do so through opening a spread betting or CFD trading account, so read our article on CFDs vs ETFs.
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 out-sized by many mutual funds.
FAQ
How do exchange-traded funds work?
Exchange-traded funds (ETFs) work by tracking a stock index or industry sector, giving investors exposure to these underlying markets. An ETF may track a major index such as the FTSE 100, or an index that focuses on companies within the gold sector, for example. Learn more about ETF trading.
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.
How can I trade ETFs as a beginner?
Open an ETF account to start trading on ETFs as a beginner, where you can choose between a live or demo account. ETFs are generally seen as a good investment for beginner traders, as they help to diversify your portfolio and can come with relatively low costs.
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 available to trade on our platform 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.
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