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An introduction to Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) are a popular type of passive investment giving investors access to a wide range of markets. Here’s our guide to how they work to help you understand what you’re investing in.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • Why ETFs are popular.
  • What types of ETF you can invest in.
  • How to invest in ETFs.

ETFs Explained

Hello, I'm Clare and welcome to Smart Investor the show that can help you get the most from your investments.

Please be aware that although we can't offer personal advice we're hoping each episode will provide you with the insight you need to make you a smarter investor.

Funds are a good option for many people looking to invest because your money is pooled with that of other investors and then used to invest in a range of different assets often shares or bonds.

This gives greater diversification than if you were to invest yourself in the shares or bonds of individual companies and it can help reduce the risk you're taking.

However, there are different types of funds.

Some are actively managed, which means a fund manager will choose what to invest in and when to buy and sell.

Others are passively managed which means they mirror a stock market index or basket of assets and the performance follows that of the index they're tracking.

Today we're looking at Exchange Traded Funds - ETFs which are a type of passive investment.

I'm joined by Joe Parkin from BlackRock, the investment firm.

Joe, thanks for joining us.

Can you explain what an ETF is?

Yeah, sure.

An ETF, or Exchange Traded Fund is a simple and easy way to get access to investment markets.

It is a pre-defined basket of bonds, stocks or commodities that we wrap into a fund and then we list onto the exchange so that everyone can use it.

It's a very, very effective way of getting access to a large number of stocks, bonds or commodities in one simple transaction.

They're also pretty new.

What they do is, they allow all investors of all types the ability to invest in global markets without having to do huge amounts of analysis on individual stocks bonds, funds, or potentially go through an advisor.

So there's a large choice.

What can people invest in via an ETF?

ETFs have certainly democratised the way people invest.

It's also given them the ability to invest in countries, regions themes, sectors and all asset classes with one simple transaction.

I think the key to point out is, because it's a passive fund it will only ever track and it will never beat the.

The benchmark is definitely at the core of every single ETF.

This benchmark is pre-defined.

Then what we do is, we then go and track that index.

What you'll get is the performance of the index minus the cost of us running the portfolio.

This differs to an active manager who always tries to beat the benchmark over a period of time but typically charges higher costs in order to do that.

What role can they play in an individual's portfolio?

ETFs can play many roles in an individual's portfolio.

One of the things to realise first up is that ETFs and active funds can co-exist in the same portfolio.

I think actually they work very well in the same portfolio and can complement themselves to build better portfolios.

In terms of the ETF there are three key areas we see individuals using them in their portfolios.

The first is a core holding.

At a relatively low cost, you can get access to global equity or bond markets.

Secondly, they can be used tactically to take advantage of a market event or a political situation.

And finally, they can be used to diversify your portfolio.

Typically, active fund managers are concentrated within their own market or sector.

An ETF provides diversification to that active manager and helps you to build a better portfolio.

So regardless of the investor and their experience an ETF, if somebody is looking to invest, is something worth considering?

Most definitely.

ETFs are just another tool investors use to build better portfolios in the same way they use equities, bonds and funds.

Great.

Thank you very much for that, Joe.

If you'd like more information about ETFs or other types of funds please visit our website.

Thanks for watching and we'll see you next time.

Exchange Traded Funds (ETFs) are becoming increasingly popular among investors looking to build a diversified yet low-cost portfolio. However, there are different types of ETFs with varying levels of risk, so you should have a solid understanding of how they work before you invest. Read on to find out more, including how you can hold ETFs in a tax-efficient account like an investment ISA.

Why are ETFs popular?

ETFs offer investors access to a wide range of financial markets around the world at a fraction of the cost of investments funds. Most ETFs are passive investments, meaning they aim to track the performance of an underlying investment. Actively managed funds such as investments trusts, on the other hand, try to outperform the market, and therefore charge more to cover higher transaction fees and the cost of employing a team of analysts.

To put this into context, the ongoing charge for the Vanguard FTSE 100 UCITS ETF, which tracks the FTSE 100 index, is just 0.09%. According to the UK Government’s Money Advice Service, actively managed funds typically charge from 1-1.5% The difference may not sound like much over the course of a year, but it adds up if you hold your investment for a number of years.

Passive investing may sound dull, but studies1 show that the average active fund manager underperforms against the market once costs are taken into account. So unless you can manage to pick a manager who consistently outperforms the market, it’s worth considering the lower cost option of an ETF. Don’t forget though, you still have to take into account any transaction and management fees charged by your investment provider.

ETFs also help investors build a diversified portfolio. They’re listed on the stock exchange, so you can buy and sell shares in them just like you would in any other company. This means you can build and rebalance your portfolio relatively quickly and easily. What’s more, ETFs don’t just track market indices. They also invest in specific sectors, such as finance or healthcare, as well as other investments like Government or corporate bonds.

Remember, regardless of whether you invest in an active or passive investment, it can fall in value as well as rise. You may end up getting back less than you invest.

What types of ETFs can you invest in?

There are two types of ETF: physical and synthetic.

Physical ETFs invest directly in whatever they track. In the case of a FTSE 100 tracker, the ETF invests in the shares of companies that make up the FTSE 100 Index, while a gold ETF invests in gold bullion held in a vault. Nevertheless, it’s important to note that when you invest in an ETF, you buy a stake in the ETF itself, not the index being tracked or the underlying investment.

Synthetic ETFs are more complex. They purchase ‘swaps’ - a type of derivative, usually sold by investment banks - which promise to pay the same returns as the index or underlying investment they track. They allow you to invest in markets that might be hard to access otherwise, such as perishable commodities or stock markets that restrict foreign investment.

Synthetic ETFs are riskier than physical ETFs due to what’s known as ‘counterparty risk’ which means if the investment bank that has sold the swap to the ETF can’t meet its obligations, you could lose out. Sellers of swap contracts usually have to provide collateral to reduce this risk. However, physical ETFs are easier to understand and less vulnerable to hidden risks, so they’re more suitable for individual investors.

Your money is still at risk though. As with other types of investment, the value can fall meaning you end up with less than you invest.

How to invest in ETFs

As mentioned earlier, ETFs trade like shares so you can add them to your portfolio relatively easily. You can hold most ETFs in an investment ISA, a tax-efficient account which protects your returns from capital gains and income tax. Just make sure you check with the ETF provider if it’s eligible for an ISA. This tax year you can put up to £20,000 tax-free into an investment ISA.

Alternatively, you can split your allowance between a cash, investment, innovative finance and a lifetime ISA if you want to and all gains will be free from income and capital gains tax. However, with a lifetime ISA,2 you can only pay in up to £4,000.

Tax rules are subject to change though, and their value to you will depend on your personal circumstances.

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