What is an exchange-traded fund?

By Deputy editor Tim Bennett May 24, 2012

Tim Bennett

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Tim Bennett looks at one of our favourite investments - exchange traded funds - and explains what they are, why we like them, and what their drawbacks are.

Exchange traded funds

An exchange traded fund (ETF) is an equity-based product combining the characteristics of an individual share with those of a collective fund. Like unit or investment trusts, ETFs track a group of shares or an asset (eg gold), giving diversified exposure to a market or sector.

Unlike with most funds, the shares held are defined in advance so that when you buy, you know what will be in the fund. This makes ETFs similar to standard index funds, but they're more flexible: they can be traded through a stockbroker at any time in lots of any size. And costs are low: management fees tend to be around 0.5%, as opposed to the 1% charged by most trackers. ETFs can also be held in an individual savings account or a self-invested personal pension.

• Entry from MoneyWeek's Financial glossary .

• Watch all of Tim's video tutorials here

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Published in Video tutorials | More articles by Tim Bennett

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  • 1. Mr T

    (25 May 2012, 01:17PM)  Complain about this comment

    Silly question perhaps, but would a ftse100 ETF gain the benefit of dividents? Or will it only track the share price?
    Thank you!

  • 2. Tim Bennett

    (25 May 2012, 03:31PM)  Complain about this comment

    Mr T - not a silly question actually! Quite a few index tracking etfs pay dividends and have a quoted yield. It should be clear from the issuer's fact sheet whether this is the case.

  • 3. Stuart

    (26 May 2012, 03:07PM)  Complain about this comment

    You explained the difference between ETF,s and unit trusts, however the benefits of ETF,s (liquidity etc) seem to be a modern twist on tracker investment trusts, but with IT,s they hold the actual stock rather than possible derivertives. Is this right.

  • 4. Islander

    (26 May 2012, 03:31PM)  Complain about this comment

    My questions somewhat overlap with Stuart's.
    1. What is the difference, apart from stamp duty, between an ETF tracking the FTSE All-Share Index, and an investment trust doing the same? I realise that stamp duty is charged on buying an IT and not on an ETF, but presumably that cost difference evens out somewhere along the way?
    2. Why would buying an ETF tracking the FTSE All-Share Index be any better than, say, the Edinburgh UK Tracker IT, which has a TER of 0.3 per cent?
    3. You touch on the difference between physical and synthetic ETFs without, I think, ever using the word synthetic, and without, I suggest, drawing sufficient attention to the risks inherent in synthetic ETFs. Radio 4 recently devoted a whole programme to these risks recently. How can I be certain that I am investing only in physical ETFs when buying a basic UK or US stock market tracker?

  • 5. Tim

    (26 May 2012, 06:00PM)  Complain about this comment

    Stuart & Islander - on a simple index tracking ETF versus an investment trust, the main criteria for choosing are 1. Cost - Vanguard have launched funds with a TER as low as 0.1% for example and 2. Tracking error - investment trust share prices are set independently by the market whereas an etf structure (like a unit trust) allows institutional investors to redeem blocks of shares against etfs. In short this means that like a unit trust there is rarely any premium or discount to NAV as there can be with an IT (even a tracker). On the point about synthetics, yes this should be checked using the relevant fund fact sheet/your broker.

  • 6. Tim

    (26 May 2012, 06:07PM)  Complain about this comment

    For those readers already familiar with unit trusts and investment trusts, the easiest way to see an ETF is as an exchange traded unit trust. The best ones combine the best features of an IT and a UT but I would accept there are pitfalls that any novice investor should watch out for. On the funds page of this week's magazine I point out one or two "under the bonnet" checks worth doing on any tracker funds, whether structured as a unit trust, IT or ETF.

  • 7. Islander

    (28 May 2012, 12:08AM)  Complain about this comment

    Thanks for your comments Tim. Not sure about the Vanguard ETFs, given that they've only just launched in the UK, and that they don't offer a FTSE All-Share Index tracker. I still rather prefer the Edinburgh UK Tracker IT, but whether Aberdeen can be trusted not to try and change this into a managed trust, as it's currently doing with its US Tracker IT, is another matter.

  • 8. Ian

    (02 June 2012, 08:51PM)  Complain about this comment

    Hi Tim, good video. But what about the counterparty risk of holding an ETF? For example, it makes sense to hold some gold bullion in case the global stock markets start to go down the tubes again and we see a panic rush to gold. However, if you hold a gold ETF you might find the company you bought it from is no longer trading after the crisis has kicked in, which leaves you having to seek legal recourse.

  • 9. John

    (25 June 2012, 11:01PM)  Complain about this comment

    Thanks for the video. A question - how do ETFs take their annual charge? In other words, if I buy an ETF now and hold it for several years, how will the issuer be able to levy the annual charge? I can see that, for an ETF paying dividends, they could take some of the dividend payment, but how about for an ETF that's purely about growth? Thanks!

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