Exchange Traded Fund

What is an ETF?

ETF stands for Exchange Trade Fund. ETFs are collective investment vehicles that hold a basket of underlying investments, with the aim to track a particular index, stock market or commodity. They often hold investments such as shares and bonds.

ETFs have some very similar characteristics to mutual funds. For example, their value is based on the performance of the underlying investments and they’re ‘open-ended’, so units can be created and destroyed based on supply and demand.

The main difference between the two is that ETFs trade on a live exchange, with a live market price, whereas mutual funds do not.

How do ETFs work?

ETFs are designed to track the performance of an index or benchmark by holding a basket of investments that make up the underlying index. This can be achieved in three main ways:

Fully replicated ETFs hold every investment, in the same proportions, that are included in the index they aim to track. For example, an ETF tracking the FTSE 100 – the UK’s biggest 100 companies – would hold shares in all 100 companies.

Partially replicated ETFs don’t hold every investment within the index. Instead, the ETF manager will hand-pick investments to try to keep the fund moving in-line with the performance of the index it’s attempting to track. This is called "optimisation" for shares and "sampling" for bonds.

For an ETF manager building a portfolio of shares to perform in-line with the FTSE 100 index, they might choose to focus on shares in banks, oil & gas miners and utilities companies, as these sectors make up a large percentage of the index.

Synthetic ETFs are the opposite to fully replicated ETFs – they do not hold the underlying investments. Instead, synthetic ETFs use a type of derivative called a ‘swap’. This is essentially an agreement with an investment bank to match the return of the index.

ETFs are open-ended collective investments, which means lots of investors’ money is pooled together into one investment fund. Units in an ETF can be created and destroyed, so the price isn’t affected by investors buying and selling the ETF. This is different to shares where there’s a set number in circulation.

An ETF’s price will move up and down based on the performance of the underlying investments – whether that’s shares, bonds, currencies or commodities. With all things being equal, if the FTSE 100 index moved up by 1%, the FTSE 100 ETF should move up 1% too.

ETF costs, currency exchange rates, and replication methods can sometimes cause tracking error between the ETF and its benchmark.

Types of ETFs

ETFs come in different shapes and sizes, offering investors the opportunity to gain access to investment in hard-to-reach areas, such as commodities or overseas markets.

Here are some common types of ETFs available on the market:

Bond ETFs

Bond ETFs invest into a basket of bonds and aim to provide a regular income for investors, meaning they can act as useful building block for an income portfolio.

Bond ETFs include investments such as government bonds (GILTs) and corporate bonds, which tend to be less volatile than shares, offering a relatively conservative way to invest.

Index ETFs

Index ETFs aim to track the performance of a particular stock market index or benchmark by holding the underlying investments. A fully replicated FTSE 100 ETF, for example, will look to replicate the performance of the FTSE 100 index by holding the 100 shares included in the index in the same proportions.

It may not track the index exactly because of trading costs and management fees – also known as tracking error.

Commodity ETFs

Commodity ETFs allow investors to access a range of commodities, from precious metal, such as gold and silver, to agricultural produce like coffee or wheat. They will track the price movements for the commodity in question.

While we don’t think investors should consider commodity ETFs as a ‘core’ investment, they do offer something different, which can means an extra layer of diversification for a portfolio.

Currency ETFs

As the name suggests, a currency ETF’s objective is to track the performance of currency pairs (exchange rates) for domestic and foreign currencies. For example, the spot price between GBP and USD.

Currency ETFs are sophisticated investments and are often used to speculate on short-term market movements off the back of political or economic events. We think investors are better placed by investing for the long term – that’s at least five years. With that in mind, most investors should avoid getting involved.

Inverse ETFs

Inverse ETFs give investors the chance to profit from a declining market by short selling. If the price goes down by 2%, an inverse ETF should rise by the same amount. This is the opposite to ‘traditional’ investing, where investors benefit from a rising stock market.

These types of ETFs use derivatives to speculate on a market decline, this adds counterparty risk. If a counterparty ran into financial difficulties, there is a chance that the ETF could lose money, cease trading temporarily or be wound up altogether.

Similar to currency ETFs, inverse ETFs are primarily used to speculate on the short-term direction of the stock market. For that reason, we think it’s wise for investors to stay clear.

Leveraged ETFs

Leveraged ETFs are collective investment funds where lots of investor’s money is pooled together into one investment. They’re designed to multiply the short-term performance of a particular stock market, index or commodity – things like the FTSE 100 index or the price of gold. Like shares, they trade on a live exchange with a live market price.

Let’s take a FTSE 100 2x daily leveraged ETF as an example. It aims to replicate two times the daily percentage change in the FTSE 100 index. If the index goes up by 5%, the ETF would go up by 10%. Likewise, if the index went down by 5%, the ETF would go down by 10%.

Leveraged ETFs are high risk and complex investments. For that reason, they are only suitable for knowledgeable and experienced investors.

Do ETFs pay dividends?

Yes, they can. However, dividend pay-outs depend on the ETF you invest in.

ETFs that hold shares or bonds are more well-known for their dividend-paying credentials. Other ETFs, for example commodity or currency ETFs, do not pay dividends as the underlying investments don’t generate an income.

Any income you receive from investing isn’t guaranteed and shouldn’t be classed as a reliable source of income.

Some ETFs are registered as ‘accumulation’ units, which means any income generated from the underlying investments are reinvested back into the fund at source. This is reflected in the unit price for the ETF and investors do not receive any additional units.

ETFs set up as ‘distribution’ units, however, pay-out any income generated from the underlying investments as a dividend.

Are ETFs lower-risk than stocks?

All investments carry a degree of risk, some more than others. This is the case for ETFs.

Two different commodity ETFs are essentially the same type of investment on the surface. However they can act very differently. For example, an ETF tracking the price of oil is likely to be more volatile than an ETF tracking the price of gold. That’s because the price of gold has, in the past, been a lot more stable and is often perceived as a 'safe haven' when markets are in turmoil. Past performance isn’t a guide to the future though.

The bottom line is ETFs can be lower-risk than stocks, but there’s no blanket rule and investors will need to look at risk on a case-by-case basis. One of the best ways to reduce the risk of investing is to build a diversified portfolio – one that’s invested across a broad range of investments in different sectors and geographies.

How to buy and sell ETFs

ETFs can be bought and sold through a stockbroker or investment platforms in the same way as other investment types like shares, bonds and investment trusts. They trade on a live exchange with a live market price.

Some ETFs, depending where they’re invested, can be complex and should only be considered by experienced investors who fully understand their risks.

When investing in complex investments with HL, you might be prompted to complete a questionnaire to check your knowledge and experience of investing. This can be completed from the ‘share dealing and live prices’ tab, once you log into your HL account online.

Most ETFs can be held across ISAs, SIPPs and standard trading accounts. You can find the full list of ETFs available through HL by using our ETF search tool.

To find out more on ETFs, how they work and the costs involved, visit the ETF knowledge centre.