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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.

Learn in 10 – Exchange Traded Funds

Short on time? Watch this quick 10 second video on Exchange Traded Funds (ETFs).

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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