What are ETFs and are they a good investment?

UK investors have been slower to get involved with ETF investing than their US counterparts, but that appears to be changing. Here we explain what ETFs are and whether they might be a good investment.

Exchange-traded funds (ETFs) are a type of investment offering investors easy access to a wide range of markets and assets. They are popular with those looking to build a low-cost, diversified portfolio.

There are different types of ETFs with different levels of risk.

In this article, we cover:

• What is an ETF investment and how does it work?
• How can you invest in ETFs?
• Are ETFs expensive?
• Do ETFs pay dividends?
• Are ETFs a good investment: the experts’ views?

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What is an ETF and how does it work?

Exchange-traded funds (ETFs) were developed in the nineties and allow investors to buy funds in the same way that you would buy shares in individual companies.

The basic idea is that an investment firm buys a pool of assets, then issues shares in that pool allowing people to buy and sell them.

For example, if the firm bought 100kg of gold, people could buy and sell shares in that – effectively letting them own fractions of the gold and trade it easily without having to worry about storing it or finding a buyer.

Shares are listed these on a stock exchange, such as the London Stock Exchange or New York Stock Exchange, and can be held in portfolios, SIPPs and ISAs in the same way traditional shares are. 

Most ETFs provide what is called a passive investment, meaning that they simply track the level of an index such as the FTSE 100 or S&P 500. You can get actively managed ETFs, which have fund managers selecting the stocks or bonds within the fund. 

There is also a third category of ETF: thematic or ‘smart beta’ ETFs, which sit between active and passive. These are more tailored than a purely passive ETF, but do not go as far as having fund managers picking each individual stock which backs the fund. 

These funds will select a broad basket of stocks which fit a given characteristic then create the ETF backed by them. They will not typically have the underlying holdings adjusted by a fund manager on a regular basis. 

A good example of a thematic ETF would be one which targets companies involved in the artificial intelligence industry.

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How can you invest in ETFs?

ETFs can be bought in the same way as stocks on online investment platforms and orders are usually completed within a few seconds. 

The platforms will hold your investments in your account and distribute any dividends in the same way as with shares. 

Just as when buying stocks, you can only do this Monday to Friday during market trading hours. You can place orders outside of these hours, but they will not execute until the market is open again. 

Are ETFs expensive? 

ETFs are generally a cheap, cost-effective way to invest. While there will always be exceptions, most ETFs come with ongoing low fees that amount to a fraction of a percent. For example, a typical FTSE 100 tracker ETF might come with a fee in the region of 7 basis points.

With 100 basis point equaling 1%, that means the fee is 0.07% of the total amount you hold. 

More complex ETFs, such as thematic ETFs, will usually come with higher fees. You can expect to pay between 0.06% to around 1% at the top end for ETFs that are unlined by active management.  

There will be a one-off cost when you buy or sell an ETF, as you would find with buying company shares. This trading fee varies by platform but is typically several pounds. Some platforms offer ‘free’ trades if you sign up to a monthly subscription package. 

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Do ETFs pay dividends?

Yes, ETFs can pay dividends in one of two main ways. As with other types of fund, ETFs can offer accumulation and distribution options.

An accumulation ETF will automatically take your share of the dividends paid out by the underlying investments and use it to increase the size of your holding.

A distribution ETF will simply pass your share of the dividend pot to you. It will appear as a cash balance in your investment platform account. You can then choose to invest this money or withdraw and spend it. 

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What are the benefits of investing in ETFs? An expert view

“ETFs offer instant diversification because they hold a basket of underlying assets, such as stocks or bonds,” said Tom Bailey, head of research at HANetf. “This can help spread risk and reduce the impact of a single stock’s poor performance. 

“This has historically been the case with ETFs tracking broad market indices such as the S&P 500 or the FTSE 100. It is one of the key benefits when compared to individual stock picking.”

“Rather than trying to find the needle in a haystack, buy the whole haystack” – Tom Bailey, head of research at HANetf.

Bailey adds that the argument for diversification also extends to thematic ETFs, which are growing in popularity. 

“Take the example of solar energy,” he said. “Say, an investor believes solar energy is going to undergo rapid growth due to declining costs and government climate change policies. How does the investor express this view? 

“Historically, an investor may have looked to identify one or two companies within the solar industry they believe stand best to benefit. But the problem is each of those stocks have individual risks as companies.” 

Bailey adds that investor may be correct in their assessment about the growth of solar but end up with exposure to a company that performs poorly due to its own specific reasons. By using a thematic ETF, the investor potentially sidesteps that issue by gaining exposure to several dozen stocks in the space. 

Liquidity is another advantage of ETFs

“ETFs trade on stock exchanges so you can buy and sell ETF shares throughout the trading day. For many this is preferable to waiting for the closing price of mutual funds,” Bailey said.

“ETFs are also more transparent than other fund structures. ETFs in Europe and the UK have to disclose their holdings daily, enabling investors to know exactly what assets they own. This is not the case with mutual funds.

“So, if you are an investor who wants to know exactly what the fund you are buying holds and in what quantities, this is a big advantage,” Bailey added.

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What are the risks of investing in ETF?

As with every investment there is the risk that the price will fall below your entry point. In investing, that risk is a necessary element. Investing profits are in essence a reward for bearing risk.   

There are some risks that are specific to ETFs, however. These are generally small, but should not be entirely discounted.

“ETFs are essentially just wrappers through which to gain exposure to assets such as stocks or bonds,” Bailey said. “The performance of an ETF is only as good or bad as the performance of its underlying assets. If its holdings are experiencing losses that will be reflected in the ETF’s performance.”

Another point to consider is the tracking difference of an ETF. If an ETF is tracking an index, you ideally want the ETF’s performance to be as close to the performance of that index as possible. Ideally, if the S&P 500 is up 10% over the year, you want your ETF to provide 10% returns. 

However, performance you get will be slightly lower than that of the index due to factors such as fees or re-balance costs, Bailey explains.

There is no way to totally eliminate tracking difference. It is part of the inherent friction of turning a theoretical index into an investible vehicle. But investors should be mindful of identifying ETFs with lower tracking differences.

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Are ETFs a good investment?

Whether ETFs are a good investment, depends on which ETF you buy. Just as with stocks or funds, they are neither all a good investments or all bad. 

The positive characteristics of ETFs discussed above certainly allow a case to be made that ETFs are in general a good way to invest. But there will undoubtably be some ETFs that perform poorly and lose money, as with stocks and other types of fund. 

Buying a simple FTSE 100 or S&P 500 tracker ETF from a well-established investment firm is about as close as you can get to reliably ‘good’ investment. It should come with a low fee, allow instant trading in or out, and is a diversified investment.

While the value of a tracker can fall in the short term, over timeframes of five years or more such ETFs are highly likely to be in profitable territory, given the historical track record of the stock market. 

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