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The basics of ETFs

In a nutshell

• Trades like a normal share on the London Stock Exchange
• Invests in a diversified mix of investments - a good one-stop shop
• Typically costs 0.1% per year
• Available on all the major platforms, but watch how they charge for them

Exchange-traded funds are the latest investment kid on the block and, boy, have they proved popular! They offer investors an easy ‘one stop shop’ for accessing global stock markets, without needing the confidence to try and identify any winners. Think of them like a playlist which will collate the Top 40. No-one is picking their favourites – you’re just getting a collection of the biggest investments in any one market or sector.

The most popular ETFs track major indices such as the FTSE All Share or S&P 500. But they can also be a simple way to back a bigger trend – Clean Energy or Biotech, for example. Their ease and low costs are driving massive growth. Data from the EPFR shows that assets in ETFs exceeded $10tn by late 2021.

Are ETFs right for me?

The best-selling ETFs

Popular ETF picks

What are other people choosing to invest in? Learn from the wisdom of crowds to get a shortlist of ETFs you may wish to consider. Here are the best-selling ETFs of May 2022.

ETFs May 2022ETFs May 2022

The benefits of ETFs

  • Access to a ready-made, diversified bunch of investments

  • Allows you to invest in a wide range of companies across the world in one place

  • Cheap as chips and easy to invest

  • You can also invest in commodities, including gold or oil, and fixed income options

What you need to know about ETFs

What sort of ETF do I need?

We’ve said it before and we’ll say it again: the right ETF for you depends on your personal circumstances. Can you squirrel money away for a long time and therefore cope with the ebb and flow of markets? Does the thought of taking a risk with your capital scare you? A good starting point would be a diversified global index, such as the MSCI World. This would give you exposure to an impressive roster of global companies – Apple, Microsoft, Proctor & Gamble, Nestle.

As you get more confident, you may want to add in areas such as emerging markets or specific sectors such as artificial intelligence. Commodities can be volatile, but areas such as gold can be a good option in tricky market conditions. That said, there won’t be as much choice in areas such as smaller companies or property and it can be better to look for an active fund.

How much do ETFs cost?

Exchange traded funds trade just like a normal share. As such, you buy them in much the same way as you would shares, such as in Shell or HSBC. That means using a broker - either an online investment platform - or through a conventional stockbroker. See our guide here.

The broker will charge a commission on buying and selling. You will also pay stamp duty of 0.5% when you buy. There is also an annual management charge for the ETF. This is usually relatively small, particularly for large, popular trusts based on well-recognised indices. Niche ETFs may charge a little more. There will also be something called a ‘bid/offer spread’ – a bit like a currency exchange, there is a gap between the price the broker is willing to sell and the price they buy.

In practice, the price charged by the broker can vary considerably. If you’re making regular payments into an ETF, these costs can mount up, so it’s worth paying attention.

Active or passive?

The experts are really fond of debating this one, but for the trainee investor, it is unlikely to matter very much. In general, a passive fund will track an index, while an active fund has a real human picking companies for you. As a passive fund doesn’t need anyone to manage it, they tend to be far cheaper. However, it does mean that you're stuck with the index performance – no-one is going to sell out of BP or HSBC because they’ve had a bad set of results. At the same time, the index is likely to be concentrated in a number of large companies. In the UK, that is HSBC, Shell and GlaxoSmithKline. In the US, it’s Apple and Microsoft. That may be totally fine, but you need to know that’s what you’re getting.

The problem is that if you’re paying a real human to pick the right stocks, you have to be reasonably comfortable that they’re going to do better than the index. That doesn’t always happen. In practice, some fund managers tend to stick nervously close to the index weightings. Good fund managers can add a lot of value of time, sometimes many multiples of the index return, but it’s not always easy to find them.

A final thought is on environmental, social and governance considerations. It's often easier for active managers to incorporate this type of assessment into their process. As such, if you want your money to do good, it can be easier to do this through active funds.

Why is the market price sometimes different from the net asset value (NAV) of an ETF?

This a slight complexity of both ETFs and investment trusts. They trade on an exchange, therefore the price is determined by supply and demand (the ratio of buyers to sellers). In theory, this should mirror the price of the underlying assets (its ‘net asset value’), but this doesn’t happen all the time. If an ETF is popular, it may trade on premium to its net asset value (NAV); if it’s unpopular, it may trade on a discount.

Usually, this is more of a problem with niche ETFs. It doesn’t tend to happen with the large, popular ETFs, where there are lots of buyers and sellers and the price reflects the value of the underlying assets.

Good to know...

Indexing - ETFs usually track an index. This has upsides and downsides. Most indices are weighted to the largest stocks. If you’re comfortable holding BP or GlaxoSmithKline (or Apple or Microsoft in the US) - great! If you’d rather invest in something a little more adventurous, such as smaller companies or single investments, perhaps ETFs aren’t for you.

Fees - ETFs are cheap on almost any measure. Given that costs are one of the very few elements of investing that are totally predictable, it can be sensible to look for lower cost investments, and ETFs fit the bill. That said, they’re cheap because there is no fund manager overseeing the investment selection. If you’d prefer to get a human involved, again, an ‘active’ fund may be a better option.

Buying and selling - ETFs trade on an exchange. That means you can buy and sell at any time during the trading day and you’ll know exactly the price you’re getting (unlike for unit trusts, which only trade once a day and where the sale price won’t be clear). This makes ETFs a good option for investing (or selling) quickly.

Diversification - Indices will include lots of different companies (usually clearly marked in the name – FTSE 100, S&P 500, and so on). As such, you’re getting lots of companies all in one place. Diversifying across a range of assets in this way is good investment practice. Doing it via an ETF is usually better - and cheaper - than trying to do it yourself by buying lots of different companies.

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