Exchange-Traded Funds enable you to gain diversified exposure to a stock market or sub-sector by investing in just one security.
- Level: For beginners
- Reading duration: 5 minutes
What to expect in this article
- Invest in entire markets with just one ETF
- Physical and Synthetic ETFs
- How physical ETFs work
- How synthetic ETFs work
Exchange-Traded Funds (ETFs) have revolutionised investing when it comes to getting cost-effective and easily traded exposure to different asset classesand markets.
ETFs operate just like old-fashioned mutual funds, with the big difference that ETFs are listed on the stock market, unlike mutual funds.
While you can trade classic funds only once a day, you can buy and sell ETFs just like stocks at any time during stock exchange opening hours.
And because ETFs are index-tracking funds, there are no expensive fund managers or analysts to pay for. This makes ETFs much cheaperthan active funds, which are managed by fund managers - and the ironic thing is: in the medium term, index funds beat most actively managed funds, too!
justETF tip:Learn all about the advantages of ETFs in our article.
Invest in entire markets with just one ETF
By buying a single ETF, you can easily and inexpensively replicate the performance of a stock market index consisting of hundreds or even thousands of listed companies.
ETFs also allow you to do the same with indices on other asset classes, such as bonds or commodities.
Physical and Synthetic ETFs
But how do ETFs track indices?
There are two different kinds of ETF:
- With a physical ETF, the ETF provider attempts to track an index by buying the underlying assets of the index with the same weight as in the index, in order to mirror its rise and fall (full replication). If the ETF provider only invests in a selection of the assets, this is called sampling.
- Alternatively, the ETF provider may enter a contract with an investment bank to provide the return of a particular index in exchange for a fee. This is called a synthetic (or swap-based) ETF.
How to invest in a specific theme, index, region, country or sector?
Dividends, bitcoin or renewable energies: With ETFs you can invest in themes and current trends.
To our investment guides
How physical ETFs work
To construct a physical ETF, the provider purchases all or a selection of relevant securities from the index to replicate it.
For instance, an ETF designed to track the FTSE 100 index of leading UK shares holds all the companies in the FTSE 100, in proportion to their weighting in the index. For example, if HSBC bank has a 7% weighting in the FTSE 100 index, the ETF provider seeks to invest 7% of its fund's assets into HSBC shares.
However, there are also cases where it is not possible or more attractive in terms of the cost-benefit ratio not to hold all the components of the index in the ETF as well. For example, an ETF provider may invest in only a selection of the securities in the index in order to replicate the performance of the index. This replication method is referred to as sampling or optimized sampling if the selection of securities is based on a quantitative method for process optimization.
This replication method is used in particular for very large stock indices with several thousand shares, such as the MSCI ACWI. In sampling, the ETF provider attempts to reduce the cost of replication by investing only in selected stocks that it believes best replicate the index performance.
How synthetic ETFs work
A synthetic ETF does not directly invest in the index’s constituents.
Instead, the synthetic ETF enters into a contractual agreement with an investment bank, with the latter promising to pay the ETF provider the daily return from the index being tracked, plus any dividends due, in return for a fee.
A synthetic ETF can therefore track an index very precisely (before fees) since the investment bank has agreed to pay the exact return to the provider.
Synthetic ETFs can be particularly useful for accurately tracking less liquid markets, where it may not be easy to implement a cost-effective physical ETF. Some asset classes, such as commodities or the money market, can even only be replicated by synthetic ETF replication. A potential downside of synthetic ETFs is the introduction of so-called counterparty risk, due to the swap transaction with a third party.
justETF tip:In the ETF search, you can easily select your personal preference regarding the replication method of ETFs with the filter criterion "Replication Method".
FAQs
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure while helping to diversify your portfolio.
How do ETFs work for dummies? ›
A cross between an index fund and a stock, they're transparent, easy to trade, and tax-efficient. They're also enticing because they consist of a bundle of assets (such as an index, sector, or commodity), so diversifying your portfolio is easy. You might have even seen them offered in your 401(k) or 529 college plan.
How do you explain what an ETF is? ›
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.
How do ETFs work under the hood? ›
ETFs do not involve actual ownership of securities. Mutual funds own the securities in their basket. Stocks involve physical ownership of the security. ETFs diversify risk by creating a portfolio that can span multiple asset classes, sectors, industries, and security instruments.
How does ETF work example? ›
An ETF provider takes into account the universe of assets, such as stocks, bonds, commodities, or currencies, and builds a basket of them, each with its own ticker. Investors can buy a share in that basket in the same way they would buy stock in a firm.
How do you actually make money from ETFs? ›
Traders and investors can make money from an ETF by selling it at a higher price than what they bought it for. Investors could also receive dividends if they own an ETF that tracks dividend stocks. ETF providers make money mainly from the expense ratio of the funds they manage, as well as through transaction costs.
How does your money grow in an ETF? ›
Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.
Are ETFs good for beginners? ›
The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.
What are the disadvantages of ETFs? ›
Disadvantages of ETFs. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ETFs are traded on the stock exchange like an individual stock, which means that investors may have to pay a real or virtual broker in order to facilitate the trade.
How is ETF different from stocks for beginners? ›
Stocks typically offer higher growth potential than ETFs, but they are also more volatile and risky. ETFs are more diversified, so they may be less risky than individual stocks, but they may not offer as much growth potential.
One way to think about it is every three months taking whatever excess income you can afford to invest – money that you will never need to touch again – and buy ETFs! Buy ETFs when the market is up. Buy ETFs when the market is down.
How are ETFs risky? ›
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
What do you actually own with an ETF? ›
Exchange-traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don't own the underlying assets in the fund.
Should I just put my money in ETF? ›
ETFs can be a great investment for long-term investors and those with shorter-term time horizons. They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks.
What is the downside to an ETF? ›
The greatest risk for investors is market risk. If the underlying index that an ETF tracks drops in value by 30% due to unfavorable market price movements, the value of the ETF will drop as well.
When you buy an ETF, where does the money go? ›
An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.
How do ETFs get paid? ›
ETFs pay dividends earned from the underlying stocks held in the ETF. An ETF that receives dividends must pay them to investors in cash or additional shares of the ETF. Dividends may be taxed at the long-term capital gains rate or the investor's ordinary income tax rate.
