ETFs, explained

What is an ETF? Find out everything you need to know about exchange-traded funds here

etfs, explained                                 

What is an ETF, and what does ETF stand for? In short, exchange-traded funds can give you access to a range of stocks, bonds and commodities, without you having to purchase them individually.

In this article, you’ll find ETFs explained simply. We’re going to reveal how to buy ETFs, and cover some of the most common pros and cons associated with these investment funds. Buckle in everyone – we’re going to have a fund time! (Sorry).

What are exchange-traded funds?

To be honest, you can be forgiven for wondering what is an ETF. As the name suggests, these funds are bought and sold on exchanges. ETFs have exploded in popularity over the past decade or so. Back in 2008, the value of assets under management in these funds worldwide stood at just $716bn. Fast forward to 2019, and this stands at a whopping $6.1tn.

ETF examples

Let’s explain ETFs with an example. Imagine that you want your portfolio to track the movements of the S&P 500, but you have little interest in going through the arduous process of buying all of these stocks separately – and having to sell them when the index is rebalanced every financial quarter.

Many ETFs are designed to track specific indices such as the S&P 500, as well as the Nasdaq and the FTSE 100. You can buy them in the middle of a trading session, just like you would snap up stock in Coca-Cola or Apple. There are more similarities between shares and ETFs than first meets the eye, not least because of how these funds have their own ticker symbol and intraday price data.

There’s one big difference with how ETFs work when compared with a company’s stock: the number of shares in these funds can fluctuate on a day-to-day basis.

ETFs explained: The most common types

Now we’ve given a basic definition of what is an ETF, let’s go into greater detail about the types of exchange-traded funds that are out there.

Aside from those that follow the market, other popular types of ETFs include those that provide exposure to specific industries such as aviation, pharmaceuticals, or technology. This can allow you to zoom in on growth areas within the stock market. Whereas some funds focus on shares that trade in the US, it is possible to invest in ETFs that handpick equities from around the world – as well as those that specialise in stocks from developing countries.

Other ETFs out there can track the prices of commodities such as oil, corn, and precious metals like gold. There are exchange-traded funds that deliver exposure to bonds issued by corporations and governments. Elsewhere, actively managed ETFs aim to do far more than track a particular index – they aim to outperform it. This means that the composition of these funds may be radically different to the overall market, and there is a risk that these ETFs could actually perform worse.

How to find the perfect ETF

There are now thousands of ETFs out there, and it’s worth bearing in mind that some are better than others. Although you won’t want to dismiss newer exchange-traded funds automatically, there’s a lot to be said for ETFs that have been around for a few years. This is because you’ll have greater amounts of data to scrutinise, and you’ll be able to see how they have performed against the wider market over the past 12 months or five years.

A fund’s size is another crucial factor – and according to some investment experts, you’ll want to find an ETF that more than £100m in assets under management. The reason for this is simple: bigger funds have less of a risk of liquidation.

Next, make sure you keep an eye on fees. Some ETFs can command high charges and transaction costs that will end up eating into your profit margin.   

Last but not least, make sure you scrutinise the holdings of an ETF to ensure it’s giving you the correct amount of exposure to your chosen market. There’s little point in buying shares in a fund that aims to track the FTSE 100 if it doesn’t have full coverage of these constituents.

One of the best ways to achieve full diversification can be to opt for an all-world index.

ETF advantages and disadvantages

So… what are the main pros and cons associated with exchange-traded funds? Let’s take a look.

One of the main ETF advantages is how they are extremely easy to trade, meaning that you can buy or sell your shares whenever a trading session is happening. As we mentioned earlier, price data is provided throughout the day – and in some cases, you’ll also have the ability to use limit orders and stop-loss orders to protect profits and minimise losses. It’s also possible to invest in an exchange-traded fund where you’ll receive dividends from the underlying stock that it tracks.

However, as you might expect, there are some ETF disadvantages that need to be taken into account. It is possible that you’ll end up paying a higher proportion of fees than when compared with purchasing each stock in an exchange-traded fund individually. Liquidity is also important in these funds – and without it, you could find it difficult to sell your shares quickly at the desired price. Last but not least, watch out for tracking errors – discrepancies in the way that an ETF balances its constituents can result in some costly mistakes.

Is an ETF right for you?   

There’s a clear reason why exchange-traded funds have become increasingly popular since they were first introduced all the way back in the 1990s: they allow everyday investors to achieve diversification. You’ll normally find that the barriers to entry are far lower than those enforced by other investment vehicles.

Innovation in the sector means that you’ll be spoiled for choice by the ETFs available. It’s worth thinking about your goals in advance, and selecting a trustworthy provider who has cultivated a reputation for success. Of course, past performance isn’t an indication that there will be gains in the future.

Creating a balanced portfolio can be hard work, but once you’ve achieved this, you’ll have the best chance of enjoying healthy returns without having all of your eggs in one basket. Don’t forget that you can invest in tokenized ETFs right here on Currency.com.

FURTHER READING: Bitcoin ETFs explained

FURTHER READING: Best ETFs for 2020: the top performers

The material provided on this website is for information purposes only and should not be regarded as investment research or investment advice. Any opinion that may be provided on this page is a subjective point of view of the author and does not constitute a recommendation by Currency Com Bel LLC or its partners. We do not make any endorsements or warranty on the accuracy or completeness of the information that is provided on this page. By relying on the information on this page, you acknowledge that you are acting knowingly and independently and that you accept all the risks involved.
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