What Are Exchange Traded Funds?

Diversifying your portfolio involves spreading your investments across a range of different assets. One way to do that is through Exchange Traded Funds (ETFs).

An ETF is a type of fund that tracks an index or market such as the FTSE100 or S&P 500. ETFs are traded in the same way as individual stocks, which means they can be bought and sold on the stock market through an investment service such as Smart Investor just like any other share. They can provide investors with diversification and access to a whole market or sector, combined with the benefits of a share, such as continuous pricing, flexibility and continuous dealing during market hours.

ETFs are usually passive investments, meaning they aren’t actively managed by a fund manager, who picks which assets to buy and sell. Instead, the ETF fund manager aims to keep the fund’s holdings in line with the particular index it's tracking. The share price is updated by the stock exchange throughout the day. As with any other type of investment, the value of ETFs can go up or down so you could get back less than you invest.

The majority of ETFs are offshore funds. This means they're based outside the UK. Make sure you understand the taxation rules that apply before you invest. Broadly if the fund you invest in has a ‘reporting status’ and you are subject to UK tax laws, gains will be subject to Capital Gains Tax. If the fund doesn't have a ‘reporting status’, gains will be subject to income tax.

Remember that tax rules can change at any time in the future. Any favourable treatment currently available could later be altered or removed altogether. The effects of tax rules on you will depend on your individual circumstances.

Why invest in exchange traded funds?

Easy to use - they're bought and sold just like shares

Flexibility - you can use them to invest in global markets and assets that can otherwise be difficult to access

Diversification - they can be a useful addition to a balanced portfolio and allow you to access whole indices based in various countries

Clear pricing - as ETFs are bought and sold like shares, standard commission rates apply

No UK stamp duty - remember tax laws can and do change.

How ETFs work

ETFs invest everywhere in the world where there's a market that can be packaged up into an index. They can track commodity prices, bonds and other assets, as well as equities. They can be a cost-effective investment as they tend to have lower fees than actively managed funds.

An example of an ETF which tracks the FTSE 100 would be the iShares Core FTSE 100 UCITS ETF (Dist). If it's an ETF tracking gold mining activities, then the indices might be the HUI Gold Index or the Philadelphia Gold and Silver Index. An ETF offering an investment in Brazil's corporate growth might well track the Ibovespa Brasil Sao Paulo Stock Exchange Index. Please note, these are just examples and there are plenty more ETFs to choose from.

It’s a good idea to look at past performance to see how closely the ETF has matched the performance of the actual index it tracked. Remember that past performance is never a reliable indication of future performance.

Physical and synthetic ETFs

Some ETFs will track an index by buying everything in it, while others buy a selection of the stocks in that index. ETFs that trade in the underlying shares of the index they're tracking are known as 'physical ETFs'.

There are also 'synthetic ETFs', which instead of directly holding shares in a particular index, rely on specialist financial instruments, such as derivatives, to track the index. Derivatives are financial instruments that have no intrinsic value themselves, but instead their value is based on the expected future price movements of the asset to which they're linked, such as shares or currencies.

The downside of this approach is that it involves counterparty risk. This means that if the issuer of the derivatives doesn’t pay the sums due, or goes bust, you could lose some or all of your capital. If this happens you will not be protected by the Financial Services Compensation Scheme.

Make sure you understand which type of ETF you're investing in and the risks involved before proceeding. If in doubt, seek professional independent financial advice. Remember 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.