What is an ETF?
An Exchange Traded Fund (ETF) is a basket of investments usually made up of shares and/or bonds. Funds are a ready-made investment portfolio run by a professional fund manager. They provide access to a diversified portfolio for usually a much lower cost than purchasing the individual investments yourself.
When you buy an ETF, you are buying a slice of the ETF’s underlying portfolio. Most ETFs track an index – a collection of securities that represent a certain sector or region. For example, the FTSE 100 is an index that represents the largest 100 companies in the UK.
All funds are professionally managed, including ETFs. However, ETFs are usually passive products as they track an index. This means that investment decisions are guided by the attempt to replicate the performance of an index as closely as possible. Whereas, for active funds the objective is to outperform their chosen index. This is why the fees are usually lower for passive ETFs compared to active funds.
Why invest in an ETF?
There are many aspects of an ETF that can make them an attractive proposition for investors.
They are a good diversifier, easily accessible and cost effective. ETFs have risen in popularity so that there are now over 10,000 ETFs available globally.
Investors in European ETFs benefit from the UCITS framework, which provides a high level of protection for investors in funds from across the EU. UCITS ETFs are identified by the “UCITS ETF” label in the fund name.
Investors should only invest if the ETF’s objectives are aligned with their own, and there’s a specific need for the type of investment being made. You should understand the specific risks before investing and regularly review it to ensure it remains right for you.
Easy to invest
ETFs are easy to understand and come in a huge range with over 10,000 available globally.
Highly regulated
Those with the UCITS label adhere to a high level of regulation providing investors with safeguards not provided by other ETPs.
Low cost
Providing access to many stocks and various industries usually at a low cost compared to standard funds.
Can I hold ETFs in my ISA, Fund and Share Account or SIPP?
Most UK ETFs can be bought and held within an HL ISA (including an HL LISA), HL Fund and Share Account or HL SIPP. To see if a particular ETF can be bought or held within an ISA, Fund and Share Account or SIPP, please view the ETF’s factsheet.
What does it cost to buy, sell or hold ETFs with Hargreaves Lansdown?
You can buy and sell ETFs online from £11.95 per deal, this might be cheaper for frequent traders. There are no dealing fees when you invest by Direct Debit (available on selected ETFs, with a minimum of £25 per month).
It's free to hold ETFs within the HL Fund and Share Account or Junior ISA. The annual charge to hold them in the HL Stocks and Shares ISA or SIPP is 0.45% (capped at £45 p.a. in the ISA and £200 p.a. in the SIPP). For the Lifetime ISA the annual charge is 0.25% (capped at £45 p.a.).
What are the risks associated with ETFs?
In addition to the risks associated by all ETPs, which can be viewed here, ETFs also encounter:
- Index sampling risk – if the ETF uses an index sampling technique where it invests in a representative sample of shares or bonds that represent the index, there is the risk that the securities selected may not match the performance of the total index.
- Counterparty risk – this occurs when a third party is involved with some aspect of running the ETF. For example, when ETFs use derivatives such as futures or options or when they are lending stock as part of a securities lending programme. If the counterparty (the third party) ran into financial difficulties, there is a chance that the ETF and subsequently the investor could lose money. This could involve larger costs to the ETF, the ETF could cease trading temporarily or, in the worst-case scenario, be wound up altogether.
Investors should understand the specific risks of an ETP before they invest, please see the KIID for full details.
How are ETF units created/redeemed?
ETFs and index funds are made up of units which are owned by investors. However, the way these units are created for each fund type is different.
When you invest in a index fund, the cash is given directly to the fund manager to buy the investments that make up the fund. In return you receive a certain number of units in the fund which represent a proportion of the total assets.
However, when you invest in an ETF, you buy it through the secondary market – a market where investors buy and sell securities. This means units in the ETF are sold between investors rather than directly via the fund manager. Unlike shares, ETF units don’t get onto the exchange via an initial public offering. Instead, ETFs rely on a creation/redemption mechanism.
ETF units available on the secondary market are already in existence, and the investor is taking them from someone else. Units are not created or redeemed on the secondary market. Instead, they are created by a group known as Authorised Participants (APs). APs are often large brokers/dealers, that are authorised by the ETF issuer to participate in the creation/redemption process.
An AP creates an ETF unit by first buying stocks to represent the index it’s looking to track. It then passes those stocks to the ETF issuer. The ETF issuer then provides the AP with an ETF unit in exchange for those stocks, which the AP then takes away and can sell to the market and to investors.
When redeeming an ETF, the unit is passed back to the AP. They can then swap the ETF unit with the original ETF issuer for the original stocks that they offered them.
What is UCITS?
UCITS (Undertakings for Collective Investment in Transferable Securities) is a set of voluntary rules which many ETFs follow. ETFs which are UCITS compliant must follow minimum standards - that includes holding a diversified portfolio, publishing clear guidance on their charges and taking steps to safeguard investors' money.
Some ETPs are not eligible for UCITS standards - including ETCs, ETNs and US-listed products. UCITS products are not necessarily safer, nor are non-UCITS products necessarily riskier, but if a product is not UCITS compliant you should take extra care in reading the relevant issuers' documents.
Are there additional expenses with ETFs?
ETFs can have low expense ratios but they are open to certain other costs. For example, stockbroker charges for the buying and selling of the ETF or costs relating to the management of an actively managed ETF. The bid-offer spread can also be a hidden cost for investors.
It’s important you read and review all important documents, including the KIID, of any investment you’re considering. You can find these on HL website on the share page for each ETF.