What is an ETF and how can I invest?

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.

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

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.

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%.

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.

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:

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:

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

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:

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 of emerging market ETFs​ and others include:

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.

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.

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:

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.

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

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.