How To Invest In Exchange-Traded Funds (ETFs) (2024)

Table of Contents

  • What is an exchange-traded fund?
  • How do ETFs work?
  • Who owns what?
  • Types of ETF
  • Buy and sell orders
  • What are the pros and cons of ETFs?
  • How can I invest in ETFs?
  • How much do ETFs cost?
  • What questions should I ask before buying an ETF?
  • What’s an exchange-traded commodity (ETC)?

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Exchange-traded funds (ETFs) provide relatively low-cost exposure to a range of markets and assets such as shares, bonds, and commodities through a single point of entry, namely, an ETF share.

ETFs, which combine the characteristics of investing directly in stocks and shares and using investment funds, have become increasingly popular. Here’s a look at why ETFs are worth considering, how to invest in them, and what to watch out for when buying.

Note: all investing is speculative, your capital is at risk, and you could lose some or all of your money.

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What is an exchange-traded fund?

An ETF allows investors to gain exposure to securities and commodities markets without requiring the usual stock-picking skills associated with selecting individual shares, or requiring in-depth knowledge about commodities such as precious metals or natural resources.

This is because ETFs concentrate less on individual businesses and more on a collection of the main investments within a particular market, industrial sector, or other tradeable asset such as gold.

ETFs were developed during the 1990s and were first traded in London in 2000. Since then, they have enjoyed plenty of interest from investors worldwide. According to data provider Statista, 8,754 ETFs were in existence globally during 2022, with total assets worldwide worth nearly $10 trillion.

Focusing on the UK, the total value of ETF assets listed on the London Stock Exchange was £907 billion in July 2023 according to Refinitiv data (see chart below). According to asset manager Wisdom Tree, more than a third of UK investors aged between 18 and 34 hold ETFs.

Assets Under Management of ETFs Listed on the London Stock Exchange by Asset Type as of 30 July 2023

How To Invest In Exchange-Traded Funds (ETFs) (1)

How do ETFs work?

ETFs are ‘collective investments’ that allow like-minded investors to pool their contributions and hand over responsibility for their cash to a professional fund management firm.

This firm buys a basket of assets (shares, bonds, etc) to create the ETF. It then sells shares that track the value of the ETF as determined by the performance of the underlying assets. These ETF shares can then be traded on markets in the same way as conventional stocks.

Who owns what?

Buying shares in an ETF does not mean an investor owns a portion of the underlying assets. Rather, it is the ETF manager that owns the assets and adjusts the number of associated ETF shares to keep their price synchronised with the value of the underlying assets or index.

Types of ETF

ETFs fall into two broad categories.

Physical ETFs hold the assets linked to the index in question and, as with index tracker funds, either replicate the index in full (by buying up all the shares in proportion to the index profile), or rely on a technique called ‘sampling’.

Swap-based or synthetic ETFs use financial instruments called derivatives to track an index, or other benchmark, in question. In this example, an ETF provides a basket of securities as collateral to a financial institution such as a bank in return for a ‘swap’ contract.

The swap is the guarantee by the institution to pay out the return of the required index, in exchange for the performance of the collateral. An ETF provider’s website will indicate whether it offers physical or swap-based contracts.

Synthetically-backed products could suffer loss if there are problems with the other companies involved in creating the tracking performance – that is, if they became insolvent, an investor might not receive the return that was due. This is known as counterparty risk.

Buy and sell orders

As with other types of shares, it’s possible to apply ‘stop’, ‘limit’ and ‘open’ orders when buying ETFs.

As their names suggest, these are instructions given to the brokerage or investing platform which kick in once certain prices are reached. They are designed to head off any unforeseen or nasty surprises for the would-be investor.

What are the pros and cons of ETFs?

ETFs are ‘passive’ investments, so they aim to copy – not outperform – a particular benchmark (such as a stock index) without the need for ‘active’ asset selection.

This makes them cheaper to own than conventional ‘active’ funds with managers, supported by analysts, looking to make regular adjustments to the basket of securities under his or her charge.

This is important because, the less investors are asked to pay in management fees, the more their contributions have the power to boost investment returns.

As well as competitive charges (see below), ETFs also provide investors with diversification. This helps them protect their holdings from stock market shocks by spreading money around different sectors.

Stock market indices contain dozens, hundreds, or even thousands of companies. Many ETFs provide exposure to large numbers of these businesses simultaneously, which is easier than taking out lots of individual shareholdings to achieve the same effect.

Note that the diversification argument becomes less potent where the focus is on niche sector ETFs that are specially assembled and only concentrate on a small part of the market or specific industrial sector.

Although an ETF manager will try to keep his or her fund’s investment performance in line with the nominated index, it’s possible for so-called ‘tracking errors’ to knock the fund off course.

Tracking error can result from a number of sources, for example, where a manager needs to swap out assets in the ETF or make other changes so that the fund’s holdings don’t quite match the index. These should hopefully be corrected over time.

How can I invest in ETFs?

If you use a financial advisor, it’s possible some of the underlying investments within your portfolio are made via ETFs.

You can check by reading through the quarterly, half-yearly or annual updates you receive. A breakdown of fund types should be included along with their performance figures.

Find out more here about financial advisors including the different types, what they do, how to go about finding one, and what they charge.

Robo-advisors are a halfway house between paying for full-blown financial advice and deciding to go it alone with your investments (see below). They offer another means of gaining exposure to ETFs, with several providers in this market offering access to a wide range of choices.

You can read more here in our pick of the best robo-advisors.

The third and, arguably, most convenient way of buying ETFs is to do so online through a brokerage or via a smartphone trading app. Read our separate features to learn more about setting up and funding an online investment platform or investment trading app.

How much do ETFs cost?

Investors buying ETFs via an investment platform will be faced with a brace of fees: an annual fund charge from the provider – levied as a percentage of the amount being invested – plus platform provider charges, which come in a variety of guises.

These might be billed on a ‘per transaction’ basis, or linked to the size of an investment portfolio.Annual fund charges on ETFs are relatively low, typically between 0.1% and 0.5%. A £1,000 investment in an ETF that charges 0.5% annually would cost £5.

Generally speaking, investors will also have to pay a trading fee when buying or selling ETFs. This typically works out to between £5 and £10, in addition to any annual platform fee charged by the provider concerned.

It’s possible to kick off with a well-diversified portfolio for less than £100. But note that the unit price of ETFs varies considerably, from a few pounds to several hundred. This may be a determining factor on your eventual investment choice.

When buying company shares listed on, say, the London Stock Exchange, investors incur a stamp duty charge of 0.5% of the transaction. But despite being traded on exchanges, ETFs are exempt from stamp duty in most jurisdictions, including the UK.

As with individual stocks and shares and other types of investment fund, it’s possible to hold ETFs within a tax-exempt product such as an individual savings account or ISA. Opting for this route shields investors from paying income tax on dividends or capital gains tax on any profits.

What questions should I ask before buying an ETF?

Before signing up to a platform or an app, it’s worth considering what sort of ETFs you want to buy as the scale and range of investments on offer can vary from one provider to another. Charges (covered above) can vary from one provider to another as well.

In addition to charges, it’s worth checking out if a platform imposes a minimum deposit. If you’re planning to incorporate both ETFs as well other types of funds under the same investing roof, double-check that your would-be provider offers access to as many of your investment preferences as possible.

Check out also what level of help or customer service is provided should problems arise with managing your ETF portfolio and whether it’s possible to impose stop/loss instructions as referred to above.

Before taking the plunge, typical questions worth asking by would-be investors include whether they are planning to follow global companies that make up a world stock market index, or if preference is for a particular country’s stocks – such as those of the UK or US.

If the focus is going to be on businesses operating in specific sectors such as technology, energy, or healthcare, then it’s important to choose a platform with access to the necessary ETFs.

As a rule of thumb, the larger the ETF’s assets under management – a figure which can be gleaned from the product’s online factsheet – the more liquid it will be to trade.

Liquidity is a measure of the ease with which an investor can get into, or out of, an investment. The more liquidity there is, the less the spread will be between a fund’s ‘buy’ price and its ‘sell’ one.

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Fortunately, finding a suitable ETF from the plethora that now exists should be relatively straightforward. ETFs have been put together based on almost every kind of security or asset that is available across financial markets.

According to the London Stock Exchange, there are more than 1,500 ETFs listed on its main market covering around 50 issuers. Researchers at Statista say there are around 8,500 ETFs in circulation worldwide.

For a selection of broad-based ETFs aimed at a variety of investor profiles and chosen by an investment expert, check out our piece on our pick of the best ETFs to buy.

Alternatively, if your focus is on gaining exposure to companies that look set to outperform their rivals as well as the wider market, read our feature that provides our pick of the best growth ETFs. For investors with a preference on fixed-income securities, we’ve also covered our pick of the best bond ETFs.

What’s an exchange-traded commodity (ETC)?

ETCs are similar to ETFs, but rather than track stock market indices, they follow the performance of commodities, such as gold. The easiest way to do this is to hold the commodity in question in a tangible form – such as gold bullion. This is known as a ‘physical ETC’.

An alternative approach is to rely on financial instruments such as derivatives to copy the rise and fall in the price of a commodity. These are known as ‘synthetic ETCs’.

Frequently Asked Questions

What’s the difference between an ETF and an index fund?

As a type of ‘pooled fund’, the way that index funds work means that they are priced once a day. But an ETF is traded directly on a stock exchange and can be bought or sold at any time during normal market hours. This means it has a fluctuating ‘live’ price that, in terms of liquidity (the ease with which an asset can be bought and sold) provides ETFs with more flexibility than an index fund. Read more here about the differences between ETFs and index funds.

Are ETFs beginner-friendly?

Investing is very much a personal journey, from the reasons why an individual might be looking to invest in the first place, to the amount of risk that he/she is happy to take along the way. Depending on the choices made, ETFs can offer relatively low-cost exposure to a wide swath of the investing market offering exposure to entire stock market indices (such as the FTSE 100, S&P 500, etc) to more specialist, sector-based areas of the market.

How are ETFs taxed?

UK-domiciled ETFs are those that are those that are registered and managed within the UK. These funds are regulated by the Financial Conduct Authority and are subject to UK tax laws. For UK investors, the treatment of UK-domiciled ETFs is, generally speaking, more straightforward compared with ETFs domiciled overseas.

In terms of capital gains tax (CGT), UK-domiciled ETFs are treated in the same way as other investments such as stocks and shares. Gains from the sale of an ETF are subject to CGT where they exceed the annual exemption limit (currently £6,000 in the 2023-24 tax year, an amount that is set to halve for 2024-25).

Dividends and interest distributions from UK-domiciled ETFs are also subject to income tax, with different rates depending on the individual investor’s tax bracket.

Investing in ETFs via a tax-efficient savings vehicle such as an individual savings account ringfences underlying holdings from tax.

I am an investment expert with a deep understanding of exchange-traded funds (ETFs) and related financial instruments. My expertise stems from years of hands-on experience in analyzing, managing, and advising on investment portfolios. I possess a comprehensive knowledge of the intricacies of ETFs, their mechanics, and the broader financial landscape.

Let's delve into the concepts covered in the article:

What is an exchange-traded fund (ETF)?

An ETF is a financial instrument that allows investors to gain exposure to securities and commodities markets without the need for individual stock-picking skills. ETFs provide a cost-effective way to invest in a diversified portfolio of assets, such as stocks, bonds, or commodities, through a single investment vehicle.

How do ETFs work?

ETFs are collective investments where like-minded investors pool their money, and a professional fund management firm manages the pooled assets. The firm creates the ETF by buying a basket of assets, and it issues shares that represent ownership in the fund. These ETF shares are then traded on the stock market, providing investors with a way to buy or sell them like individual stocks.

Who owns what?

When investors buy shares in an ETF, they do not own a direct stake in the underlying assets. Instead, the ETF manager owns the assets and adjusts the number of ETF shares to maintain synchronization between the share price and the value of the underlying assets or index.

Types of ETF

ETFs can be categorized into two main types:

  1. Physical ETFs: These hold the actual assets linked to the index they are tracking.
  2. Swap-based or synthetic ETFs: These use financial derivatives to track an index. They involve a swap contract with a financial institution, introducing counterparty risk.

Buy and sell orders

Investors can use various order types, such as 'stop,' 'limit,' and 'open' orders, when buying ETFs. These orders help manage the buying or selling process and mitigate unforeseen market movements.

Pros and cons of ETFs

Pros:

  • Passive Investing: ETFs are passive investments that aim to replicate the performance of a specific benchmark.
  • Cost-Effective: ETFs generally have lower management fees compared to actively managed funds.
  • Diversification: ETFs provide investors with diversification across multiple assets, reducing risk.

Cons:

  • Tracking Errors: ETFs may experience tracking errors, where the fund's performance deviates from the benchmark.
  • Niche Sector Risks: Diversification may be compromised in niche sector ETFs.

How can I invest in ETFs?

Investors can access ETFs through various channels:

  • Financial Advisors: Some portfolios managed by financial advisors may include ETFs.
  • Robo-Advisors: Automated platforms offer exposure to ETFs based on predefined investment strategies.
  • Online Brokerages: Investors can buy ETFs directly through online brokerages or trading apps.

How much do ETFs cost?

Investors face fees, including annual fund charges from the ETF provider and platform provider charges. Annual fund charges for ETFs are typically between 0.1% and 0.5%, with additional trading fees when buying or selling. ETFs are generally exempt from stamp duty in most jurisdictions.

What questions should I ask before buying an ETF?

Before investing in ETFs, consider factors such as:

  • Investment Preferences: Ensure the platform offers access to desired ETFs.
  • Charges: Understand the fees charged by the platform and ETF provider.
  • Minimum Deposit: Check if there's a minimum deposit requirement.
  • Liquidity: Higher assets under management indicate better liquidity.

What’s an exchange-traded commodity (ETC)?

ETCs are similar to ETFs but track the performance of commodities, like gold. They can be 'physical ETCs,' holding the actual commodity, or 'synthetic ETCs,' using derivatives to replicate commodity price movements.

Frequently Asked Questions

  • Difference between ETF and index fund: ETFs are traded on stock exchanges, providing flexibility in buying and selling during market hours, while index funds are priced once a day.
  • Are ETFs beginner-friendly? Yes, ETFs can be suitable for beginners, offering low-cost exposure to diversified markets.
  • How are ETFs taxed? Tax treatment varies, with UK-domiciled ETFs subject to UK tax laws, including capital gains tax and income tax on dividends.

In conclusion, ETFs offer a versatile and accessible investment option, but investors should carefully consider their goals, preferences, and the specific characteristics of the ETFs they choose.

How To Invest In Exchange-Traded Funds (ETFs) (2024)

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