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Exchange Traded Fund (ETF) Explained

Beginner

What is an Exchange Traded Fund?

An Exchange Traded Fund (ETF) is a basket of investments that trade as a security. Most ETFs are designed to track the performance of an index or a basket of assets. As such they are considered to be “passive” investments and subsequently, this helps to reduce costs.

Some ETFs are “actively managed” and look to outperform the market (these come with higher management fees) but most ETFs are just tracker funds.

Various types of ETFs are available

ETFs are increasingly popular for investors as they offer a simple way to add diversity and gain exposure to a variety of asset classes including bonds, stocks and commodities. They can also come leveraged and can help to provide downside protection.

Here are some of the main types that are available:

  • Index ETFs – funds that track an index, such as the S&P 500 or NASDAQ 100
  • Sector ETFs – funds that track the constituents of a sector, such as banks or mining stocks
  • Style ETFs –funds that have stocks that follow a specific theme (such as high growth, or high yield) or market capitalisation (small cap)
  • Bond ETFs – funds that invest in bonds
  • Currency ETFs – funds that track individual currencies
  • Commodity ETFs – funds that track commodities such as gold, silver or oil
  • Inverse ETFs – funds that use derivatives to profit when markets move lower
  • Leveraged ETFs – funds that use derivatives that amplify market returns, with a leverage of 2 times or 3 times the performance of the underlying assets.

ETF management fees

All funds incur a management fee. This is the fee paid to cover the administrative costs of running the fund in addition to trading costs. With most ETFs passively tracking an index this helps to reduce fund costs.

With fewer trades and no need to pay for expensive research teams, ETFs are a low-cost way to invest in a fund (a pool of investments). It means that the annual management fee (reflected in the “expense ratio”) can often be less than 0.1% per year.

ETFs and dividends

If the ETF invests in assets that pay a dividend, such as stocks or bonds, then the fund will pay an income. This income can either be paid out to the investor or can be reinvested back into the fund.

An Accumulation fund (referred to as “Acc”) holds onto the payments and reinvests them in the fund. This increases the value of the fund. A Distribution fund (known as “Dist”) will distribute the income to the investor. This allows them to reinvest elsewhere, or just spend it. The investor makes the choice of which type of fund they want to invest in from the outset.

This does not apply to ETFs that invest in assets such as gold or commodities as there is no income from the underlying asset.

Editor

Richard is an independent market analyst with over 20 years of experience working for brokers in London. Most recently he has worked with Hantec Markets and Infinox, focusing on trading education, ana... Continued

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