What is an ETF?

David Kimberley
October 26, 2022
What is an ETF?

The who, why and what of ETFs. We explain everything you need to know about exchange traded funds.

If you’ve ever hung around people that like investing, the chances are that one of them, having finished fawning over Warren Buffet and talking about how Tesla is going to the moon, will tell you about ETFs.

ETFs — or exchange-traded funds to use their proper name — are one of the easiest ways to invest in the stock market today.

Most people will use them to track a stock index and ride the wave that the market returns. 

But that’s not all they're good for.

In fact, there are several different types of ETFs and each one provides investors with different benefits.

What is an ETF?

Before we go any further, it may be worth briefly explaining what an ETF actually is.

In their most common form, ETFs, , or exchange traded funds, are funds that track the performance of an index. 

That could be the S&P 500 or a more niche one, like the S&P 500 Capped 35/20 Information Technology Index (it tracks tech firms in case you were wondering).

As the companies that create and manage ETFs are not attempting to pick winning stocks, or any other assets for that matter, they are generally described as being passively managed — passive because they are simply matching their fund to the index they want to track and letting things play out. 

This is opposed to ‘active’ management, where a fund manager will ‘actively’ look for assets that he or she thinks are going to outperform the market and invest accordingly.

Of course, this is the annoyingly nuanced world of finance and so there are always exceptions to the rule. Some ETFs don’t track an index and others are also actively managed.

There is also an assumption that ETFs are less risky than other assets. But some of them will use borrowed money, known as leverage, to invest. 

These are all becoming increasingly popular but, at least for now, ETF in common parlance is most likely to refer to a passively managed, index-tracking fund.

Different types of ETFs

Now that’s out of the way, we can go back to looking at those different types of ETFs.

The thing to remember here is that, even though we generally think of an index as referring specifically to stocks, there are actually lots of different indices covering multiple asset types, including everything from oil to the bond markets.

But as they’re the most common, let’s start with stock ETFs.

1. Stock index ETFs

As we’ve already seen, stock ETFs tend to be the most popular option for people investing in the asset class — that’s as true for beginner investors as it is for the pros.

Stock ETFs are generally a way for you to get exposure to a large set of stocks via one investment. 

The most popular stock ETFs track big name indices, like the S&P 500. 

But others will track specific sectors, countries or regions. For example, the L&G Battery Value Chain ETF tracks an index that contains battery makers and companies that mine for minerals used to make batteries.

2. Commodity ETFs

As their name suggests, commodity ETFs give you exposure to the commodities sector. This includes a broad range of assets, ranging from gold and silver to oil and gas.

There are a few things to be wary of here. Firstly, ‘commodity ETF’ is often used to describe stock ETFs that track companies in the commodities sector. 

They are not the same thing. A commodity ETF that tracks the price of gold is not the same as buying a stock ETF which tracks the price of gold mining companies.

ETCs - Exchange-traded commodities

On a similar note, be aware that there are some differences between commodity ETFs and ETCs — exchange-traded commodities. 

In short, an ETC is a type of debt, not too dissimilar to a bond, where the issuer agrees to pay the return that a particular commodity or commodity index, say the price of gold or an oil index, provides. 

By contrast, an ETF is set up as a fund, not as a type of debt. 

The key difference that results from this is that an ETC issuer is guaranteeing payment of the commodity they’re tracking. 

That leaves you open to the risk that they could default but it also means there is less chance of tracking error, the difference between the return on the index and the actual return on the ETC.

For ETFs, there is no guarantee that they’ll pay the return the index provides, meaning that you’re more open to tracking error. But then there is a smaller chance of them defaulting.

In practice, these differences have almost no impact on investors. Buying a gold ETC or gold ETF is likely to generate almost identical returns, which is why it’s often the case that no distinction is made between the two.

3. Bond ETFs

Things are a bit less confusing with bond ETFs. A bond ETF will typically track the performance of a bond index.

For example, the Vanguard UK Gilt ETF tracks an index that measures the performance of UK government bonds. The thing to be careful of here is that there are lots of different bonds issued by governments and they’ll also have different maturity dates.

So if, for example, you are looking to invest in short-term UK government debt, make sure you aren’t putting money into a bond ETF that tracks a long-term index.

4. International ETFs

One of the big benefits of investing in ETFs today is the ability to access foreign markets comparatively cheaply.

This is possible because there are lots of ETFs that will track the performance of companies in specific countries or regions.

For example, ETFs that invest in East Asian countries have become extremely popular in recent years, as investors look to capture the growth that has taken place in China but also in much of South East Asia.

5. Sector ETFs

Aside from regions or countries, ETFs can also be used to invest in a particular sector. We’ve already mentioned the battery-tracking L&G Battery Value Chain ETF but there are plenty of others.

The iShares Digitalisation ETF is one. It tracks the performance of firms that provide digital services. 

Others may track AI businesses, real estate firms or even esports and gaming.

Popular ETFs in 2020 on Freetrade

Despite the fact that 2020 has been one of the weirdest years on record, people are still pouring money into the stock market.

It’s because of this that many ETFs, which would generally be the most susceptible to market crashes, have actually ended up recovering in line with the indices that they track over the past 12 months.

But others are yet to recover from the turmoil that we saw at the start of the year.

For better or worse, here are some of the ETFs that have proven particularly popular over the past 12 months.

Most popular stock index ETFs

Topping the charts in the Freetrade ETF investment rankings is the iShares Core FTSE 100 ETF which, if you couldn’t tell already, tracks the performance of the 100 largest companies on the UK stock market.

Not far behind it was the Vanguard S&P 500 ETF, which tracks the US index of the same name. The S&P 500 has managed to recover extremely well. In fact, it’s now trading at a higher level than it was before the pandemic.

Things are not so good for the UK stock market, which has been weighed down by Brexit talks and lacks the tech giants that have helped boost US markets this year.

Most popular commodity ETFs

We’re going to cheat on this one a little bit because the most popular commodity ETF was not really an ETF. It was actually an ETC. Yes, we made a whole big deal about ETCs not being the same as an ETF earlier in this piece but, for the purposes of most investors, it serves a very similar function. 

So with that little preamble out of the way, the iShares Physical Gold ETC proved the most popular commodities purchase on the app this year.

For those who’ve been paying attention, gold has had a wild year, reaching record highs before tapering off over the past couple of months. The reason for this is fairly straightforward. People buy gold when they think bad things are going to happen. Now that there’s a vaccine for COVID-19, bad things seem less likely to happen and so people have started to sell their gold holdings and move funds back to the stock market.

Most popular bond ETFs

Given their penchant for UK stock market ETFs, you’d have thought that Freetrade investors would be keen on UK bonds too. Alas, the most popular bond ETF was an iShares one that tracks an index of US government bonds that mature in 7-10 years time. This could be due to the relative stability of the US as a country, and its ability to keep its word on keeping up with bond payments.

Next on the list was the Vanguard USD Corporate Debt, which tracks the performance of debt issued by US companies.

Most popular international ETFs

Having experienced the SARS outbreak in 2003, many East Asian countries were much better prepared for the pandemic than countries in the West.

This has meant their economic recovery has been much better too and, as a result, investors have been happy to allocate more funds to companies in the region.

Freetrade users were particularly fond of HSBC’s China ETF. But others, focused on Japan specifically and also on the wider East Asian region, were also very popular this year.

Most popular sector ETFs

Last but not least we have sector ETFs.
And in a year in which electric vehicles have seen mind-boggling valuations and governments have called for a ‘great reset’ on climate policy, it’s not surprising that investors on Freetrade were most keen on the Global Clean Energy ETF

The ETF tracks the S&P Global Clean Energy Index, which is comprised of firms from around the world that are active in the renewable energy space.

The other sector ETFs that Freetrade investors snapped up most this year included Invesco’s Nasdaq 100 and another, managed by L&G, that tracks the performance of an index of robotics and automation businesses.

Read more: What is an inverse ETF?

ETF fees and charges 

The good thing about ETF fees and charges is that they do tend to be cheaper than actively managed funds. 

The bad thing is that you still have to pay some fees.

How much you pay will vary. It could be as ‘little’ as 0.3% per or as much as 0.7%. These charges are generally paid on an annual basis. 

Aside from this, you will probably have to pay foreign exchange fees if you are buying the ETF in a different currency. 

A note on fees

The average fee figure for funds vary between credible sources — these numbers reflect the range we’ve seen.

When checking out fees, make sure you look for the TER (total expense ratio). This percentage figure encompasses all the annual costs (management fees, admin and trading costs) on the money you hold in the ETF.

If you hold £100 in an ETF with a total expense ratio of 0.3%, you’d pay 30p in annual costs to the fund. This will be baked into the performance of the fund, rather than a separately charged fee.

You can find the TER in the KID (Key Information Document). Acronyms ahoy, right?

How are ETFs taxed?

ETFs are taxed in much the same way that shares are. They can be subject to tax on both capital gains — any profits you make from buying low and selling high — and dividends.

But remember that, even if you invest using a regular share dealing account, you have annual allowances for both capital gains and dividends tax. For the 2021/22 tax year, those are £12,300 and £2,000.

How much you pay if you go over those limits will depend on how much income you make outside of investing. 

Wrap these UK ETFs in an ISA or a SIPP, for example, and you won’t have to pay capital gains or dividends tax on any gains you make.

Like lots of things in the world of investing, there are always lots of little nuances when it comes to taxes. So if you want to get into the nitty-gritty of the subject then you can read our post about how your investments are taxed.

Read more: Five (and a half) tips to boost your dividend income

Benefits of investing in ETFs

  • Easy solution for anyone looking to diversify their portfolio
  • Simple investment for anyone that doesn’t have the time to actively manage their investments
  • Low fees
  • Liquid and easily accessible because they’re exchange-traded
  • Gain easy access to foreign markets and companies
  • Broad range of assets available to you

Dangers of investing in ETFs

  • Subject to systematic risk — if the market crashes, you’re likely to suffer losses in line with it.
  • Lack of focus on specific assets means the index winners can end up being diluted by the laggards.
  • Risk of overlap — holding lots of ETFs can mean you end up unwittingly getting exposure to the same stocks several times over.

ETF investment strategies

It seems strange to talk about ETF investment strategies given that one of the reasons they’re so popular is because people don’t want to think too much about what they’re doing.
They tend to just want to put some money into them and forget about it for a few years.

Still, like all investment decisions, it’s worth taking some time to think about what you want to achieve before you dive in.

How to pick an ETF

Picking an ETF is pretty similar to choosing a stock — or really any asset for that matter. 
Before doing anything, you want to think about your own financial position and what you can and cannot afford to do. Taking that into account will tell you how much risk you can afford to take on.

Based on that information, you can then decide what you want to buy. It may be the case that you want to just keep things simple and just invest in an index-tracking fund.
Alternatively, you may think that a particular country or sector is going to perform well and invest accordingly.  

ETFs vs investment trusts

As they both trade on exchanges and tend to have a diverse set of holdings, people often think of investment trusts and ETFs as being almost the same. 
But beyond this exchange-listed status, there isn’t much similarity between the two.

True, both tend to hold diverse sets of assets.

But trusts are actively managed. That means they have fund managers that pick stocks or other assets in the hope of generating a return for them. 

In comparison to ETFs they can also be much more concentrated, as the manager might only want exposure to a limited number of companies. This means they can be much less diversified than you think.

By contrast, ETFs are nearly always passive — all they do is try to track an index. There is no management team or group of analysts trying to beat the market. As a result, ETFs tend to have lower fees than trusts because there is much less for the people managing them to do.

ETFs vs mutual funds

Everything that’s just been said about fees applies to mutual funds too. 

Like trusts, mutual funds tend to be actively managed and so they have higher fees than ETFs.
But another key difference is that mutual funds are not exchange-traded and so tend to be much less liquid. Or in less finance-y language, it is generally much easier to buy and sell ETF holdings than it is for mutual funds, which often have one solitary dealing point throughout the day.

Any questions?

Well, that brings us to the end of our ETF adventure. If you’re still unsure about something then remember you can always get in touch with the Freetrade team and ask. 

Happy investing!

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