What is an ETF? We explain the basics of the cheap and increasingly popular way to invest in bonds and shares
You have probably heard of ETFs, as exchange-traded funds are commonly known.
But how are they different from traditional funds? Are they just for day traders and sophisticated investors? Or can ETFs be used by ordinary investors?
In this three-part series of articles, James Norton, senior investment planner for Vanguard answers common questions about ETFs and looks at how you can use them in your portfolio.
ETFs offer diversification, providing investors with exposure to a broad range of bonds, shares and other assets
The basics of an ETF
The chances are, if you’re already familiar with traditional funds, then you probably already know more about ETFs than you might have thought.
When you think of a fund, you probably think of traditional ‘mutual’ funds.
Both ETFs and traditional funds are collective investment vehicles. This simply means the funds of many investors are pooled together, allowing them to invest in a portfolio of shares or bonds.
This gives investors certain benefits. For example, sharing costs between a large number of investors helps to keep costs low.
Collective investment also offers diversification, providing investors with exposure to a broader range of securities than they could access through an individual portfolio.
As with a traditional fund, each share of an ETF represents an interest in the underlying assets, and both structures are professionally managed. You don’t need to keep track of every holding in the fund—the manager of the ETF or the fund will do that for you.
More often than not, ETFs and traditional funds are ruled by the same regulations, meaning they face similar restrictions in terms of what they can invest in and how they do it.
The crucial difference to traditional funds
But there are some key differences between ETFs and traditional funds.
As their name suggests, ETFs trade on an exchange, such as the London Stock Exchange—much like individual shares—so they can be traded throughout the day at a market-determined price, just like shares. And again like shares, their prices fluctuate over the course of the day.
Traditional funds, on the other hand, are priced once a day at what’s known as the fund’s net asset value (NAV).
ETFs and traditional funds also have different charging structures for buyers. As they are traded on an exchange, ETFs have two prices: the offer price (the price at which you can buy shares) and the bid price (the price you will receive when you sell shares). The difference between these is called the spread. There can also be stockbroker fees associated with trading them.
This is the same as with individual company shares.
Traditional investment funds (using a structure known as an open ended investment company) do not normally have a bid-offer spread, although some that are structured as unit trusts do.
However, ETFs and funds are similar in the way they charge investors an ongoing charge for the management of the fund.
In terms of cost, most ETFs use an indexing, or passively managed, approach; they’re built so that their value can be expected to move in line with the indices they seek to track – for example, the FTSE 100. Indexing has shown to be one of the lowest-cost ways to invest.
While traditional funds can also be passively managed, the majority are actively managed, whereby the manager picks the shares or bonds that they expect to beat the market. Actively managed funds typically charge higher fees than index funds and crucially, most underperform the index they are trying to beat, according to Vanguard’s The case for low-cost index-fund investing report.
ETFs can keep costs low
As you can see, ETFs are very similar to traditional funds. But it’s important to understand the small but key differences between them before deciding which is best for you.
And whatever you opt for, remember that high cost is one of the biggest impediments to investment success. Choosing a low-cost ETF or traditional mutual fund can help put you on track to achieving your investment goals.
In parts two and three of the series, we will be comparing ETFs with individual shares and bonds as well as looking at how to decide whether ETFs are right for your portfolio.