Exchange-traded funds, usually shortened to ETFs, have become one of the most popular ways for ordinary people to get exposure to markets. They sound technical, but the idea is simple: an ETF is a basket of investments that you can buy and sell on a stock exchange in a single share, just as you would a share in an individual company.
The basic idea
Imagine you wanted to own a small slice of every company in the S&P 500. Buying 500 separate shares would be expensive, slow and fiddly. An ETF that tracks the index does the work for you. The fund holds the underlying shares, and you own units in the fund. When the index rises or falls, the value of your units moves with it, minus the fund’s costs.
The “exchange-traded” part is what separates ETFs from many traditional funds. A conventional unit trust is usually priced once a day. An ETF trades throughout the session, so its price changes from minute to minute and you can see roughly what you are paying before you deal.
What ETFs can track
The most common ETFs follow broad share indices, such as the FTSE 100 or the S&P 500. Others track government bonds, corporate bonds, gold, a single sector such as banks or technology, or a theme such as clean energy. There are also currency ETFs and funds that follow commodity futures.
That range is part of the appeal. A beginner can build a diversified mix of shares and bonds with only a handful of holdings, and a more experienced trader can use a sector ETF to express a view on an industry without picking individual winners.
How an ETF follows its index
There are two main approaches. A physical ETF holds the actual shares or bonds in the index, either all of them or a representative sample. A synthetic ETF uses a financial contract called a swap, where a bank agrees to pay the return of the index. Synthetic funds can track some markets more cheaply, but they add the risk that the bank on the other side of the swap fails to pay, so it is worth knowing which type you hold.
No ETF follows its index perfectly. The gap between the fund’s return and the index return is called tracking difference. Fees, trading costs and the way dividends are handled all play a part. A good tracker keeps that gap small and consistent.
The costs to look at
The headline cost is the ongoing charge, shown as a percentage per year. Broad index ETFs are often very cheap, while niche or actively managed funds tend to cost more. On top of that you pay the bid-ask spread when you buy and sell, plus any platform or dealing fees from your broker. Popular ETFs on large indices usually have tight spreads. Small, specialist funds can be wider, especially early or late in the trading day.
For UK investors, many ETFs can be held inside an ISA or a pension, which can make a meaningful difference to the after-tax result. Our guide to ISAs versus trading accounts explains the trade-offs.
Risks worth respecting
An ETF is only as steady as what it holds. A fund tracking a volatile sector will be volatile. A fund tracking an index dominated by a few giant companies will be dominated by them too, which matters at a time when US benchmarks are setting records on the back of a narrow group of large technology names.
Be especially careful with leveraged and inverse ETFs. These aim to deliver a multiple of the daily move, or the opposite of it, and reset every day. Over several days in a choppy market the result can drift a long way from what you might expect, so they are tools for short-term specialists rather than long-term holdings.
Currency is another quiet factor. If a UK investor buys an ETF that holds US shares, the return in pounds depends on the exchange rate as well as the shares themselves.
Where ETFs fit
For many beginners, a low-cost index ETF is a sensible way to learn how markets behave without staking everything on one company. For active traders, ETFs offer quick, liquid exposure to an index, sector or asset class. In both cases the same questions apply: what does it hold, how closely does it track, what does it cost, and how much risk does it add to your overall position?
If you are working out whether you are more suited to longer-term investing or active trading, our free trader assessment is a useful next step and points to the areas worth building first.
