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What is an ETF, and How Do They Work?

An exchange-traded fund (ETF) pools together investor capital to invest across a diverse range of financial assets. But how do they work?

by | Last updated 2 Mar, 2023 | Investment Funds

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Exchange-traded funds, or ETFs, are a specialised type of investment vehicle. They pool capital from investors into a single pot that is then reinvested across a wide range of assets. The types of assets found inside an ETF vary depending on its type. But the list can include stocks, bonds, commodities, currencies, and options, among other financial securities.

ETFs behave remarkably similarly to mutual funds. However, a stark difference is the way they are traded. ETFs can be bought and sold on an exchange, such as the London Stock Exchange, at any time during the regular trading day, just like a stock. By comparison, traditional mutual funds are not traded on exchanges and can only be bought or sold once daily after the stock market has closed.

This kind of fund grant investors a convenient alternative method of gaining access to a broader range of asset classes within a single transaction.

How do exchange-traded funds work?

An ETF is a fund that can hold a variety of underlying assets. This assorted mix of investments is why they are popular among investors seeking to diversify their portfolios. After all, there is no limit to how many assets can be contained within an ETF. And it’s not uncommon to have hundreds or even thousands of positions within this investment vehicle.

Furthermore, they’re usually set up as open-ended funds. As such, there is no limit on the number of investors who can own a piece of an ETF. Similar to how a stock investor has a claim to an underlying company’s earnings, an ETF investor has a claim on a portion of the fund’s portfolio. The more shares they own, the larger the claim.

Each ETF is constructed to follow a particular investment strategy. This could be to track the performance of an index like the FTSE 100 or a commodity like gold. Similarly, an ETF could be focused on tracking the performance of a particular industry or currency. And just like a mutual fund, there are passive and active variants.

  • Passive ETFs – These funds aim to track the performance of a particular benchmark, such as a stock market index.
  • Active ETFs – These funds aim to outperform a particular benchmark through dedicated research and analysis.

The world’s first passive ETF was the Toronto 35 Index Participation Fund, founded in Canada in March 1990 to track the TSX 35 index. Three years later, in January 1993, the SPDR S&P 500 passive ETF was listed on the New York Stock Exchange Arca with the goal of tracking the S&P 500 index.

The 7 types of ETFs

Depending on the assets and strategies deployed by an ETF, there are seven different types or categories that these funds can be organised into. Each carries its own risks and potential rewards.

1. Index ETF

An index ETF aims to replicate the performance of a benchmark stock index like the Dow Jones Industrial Average. The portfolio will consist purely of the stocks found in the index it is tracking. And each position will be weighted identically to how each business is weighted inside the index.

Stock market indices are rebalanced every quarter in March, June, September, and December. And an index ETF follows suit, rebalancing the portfolio at the same time.

Because of the simple nature of this tracking strategy, almost all Index ETFs are passive, with trading algorithms executing all the trades. As such, these funds charge very low management fees.

Some examples of index ETFs include:

  • iShares Core FTSE 100 UCITS ETF (ISF)
  • iShares FTSE 250 UCITS ETF (MIDD)
  • SPDR S&P 500 ETF Trust (SPY)
  • SPDR Dow Jones Industrial Average ETF Trust (DIA)

2. Industry ETF

An industry ETF aims to replicate or beat the performance of a particular industry. These funds enable investors to gain diversified exposure to specific sectors quickly.

By investing specifically in companies and other financial assets targeted at a single sector, these funds tend to have a higher risk profile. The portfolios are exposed to specific industry risks and can be highly cyclical depending on the sector being targeted. However, this increased risk comes with the potential for higher returns versus an index ETF.

Some examples of industry ETFs include:

  • Vanguard Information Technology Index Fund (VGT)
  • iShares Oil & Gas Exploration & Production UCITS ETF (SPOG)
  • iShares S&P 500 Health Care Sector UCITS ETF (IHCU)
  • iShares STOXX Europe 60 Construction & Materials UCITS ETF (EXV8)

3. Bond ETF

A bond ETF aims to provide investors with a regular fixed income through various types of financial bond instruments. These include government bonds, corporate bonds, and municipal bonds.

Despite the portfolio consisting of debt instruments, the ETF does not have a maturity date. When a bond within the portfolio eventually matures, the capital is reinvested into another debt security to continue providing investors with a steady stream of reliable income.

Some examples of bond ETFs include:

  • Vanguard UK Gilt UCITS ETF (VGOV)
  • Invesco Taxable Municipal Bond ETF (BAB)
  • Vanguard Long-Term Corporate Bond Index Fund ETF (VCLT)
  • iShares 10+ Year Investment Grade Corporate Bond ETF (IGLB)

4. Commodity ETF

A commodity ETF aims to replicate the performance of a single or collection of commodities like gold, lumber, crude oil, sugar, or livestock. While commodities are not known for delivering impressive levels of growth, they can be a safe haven for investor capital during periods of high inflation.

Investing in commodities through an ETF can diversify a portfolio without dealing with the associated transport, storage, and insurance costs of owning physical commodities. Shares in an ETF are also significantly easier and faster to dispose of at a later date.

Some examples of commodity ETFs include:

  • abrdn Bloomberg All Commodity Strategy K-1 Free ETF (BCI)
  • Invesco DB Oil Fund (DBO)
  • SPDR Gold Shares (GSD)
  • Invesco DB Agriculture Fund (DBA)

5. Currency ETF

A currency ETF aims to track the performance of specific domestic and foreign currency pairs. These funds also provide a convenient method of speculating on swings in exchange rates based on countries’ political and economic developments without having to venture directly into the complicated arena of forex markets and financial derivatives.

In recent years, cryptocurrency ETFs have emerged, granting investors further avenues to diversify their portfolios.

Some examples of currency ETFs include:

  • BetaShares British Pound ETF (POU)
  • Invesco CurrencyShares Australian Dollar Trust (FXA)
  • iShares Currency Hedged MSCI United Kingdom ETF (HEWU)
  • Invesco DB G10 Currency Harvest Fund (DBV)

6. Inverse ETF

An inverse ETF is a special type of investment fund that seeks to generate gains by betting against stocks or assets using financial derivatives. The most common method of achieving this is by shorting stocks. If the value of a shorted asset declines, the ETF generates a positive return for investors. However, if the value of shorted assets increases, the fund suffers a loss.

Investing in an inverse ETF grants investors the ability to bet against the performance of an index, industry, bond, commodity, or currency without directly shorting the assets. Instead, this responsibility is passed onto the fund manager. However, the process and trades involved with running an inverse ETF are far more complicated than other types. As such, the annual management fees are typically more expensive.

This type of fund can carry significant risks and is usually only appropriate for experienced traders.

Some examples of inverse ETFs include:

  • ProShares UltraPro Short QQQ (SQQQ)
  • ProShares Short Russell2000 (RWM)
  • ProShares UltraShort Basic Materials (SMN)
  • Direxion Daily S&P 500 Bear 1X Shares (SPDN)

7. Leveraged ETF

A leveraged ETF is a special type of investment fund that can adopt the strategies of any of the other six categories. The key difference is that these funds use leverage to amplify returns. For example, a 3x leveraged FTSE 100 index ETF would rise by 3% every time the FTSE 100 increases by 1%. However, this relationship also works in reverse. If the FTSE 100 were to fall by 1%, the leveraged ETF would drop by 3%.

Leveraged ETFs are designed to let investors capitalise on the stock market’s short-term volatility. But it also introduces significant risk levels. This type of fund is usually only appropriate for experienced traders.

Some examples of leveraged ETFs include:

  • ProShares UltraPro QQQ (TQQQ)
  • ProShares Ultra VIX Short-Term Futures ETF (UVXY)
  • Direxion Daily Small Cap Bull 3X Shares (TNA)
  • Direxion Daily S&P 500 High Beta Bull 3X Shares (HIBL)

What are the advantages of ETFs?

Exchange-traded funds are a popular and convenient investment instrument for investors seeking to diversify their portfolios as well as put their investing journey on autopilot.

The main advantages of investing in an exchange-traded fund are:

  • Instant diversification – ETFs often contain a diverse portfolio of financial assets that investors can buy indirectly within a single transaction.
  • Low fees – Unlike a mutual fund, ETFs typically charge lower annual management fees, resulting in a lower expense ratio and improving an investment’s overall return. Having said that, there are some exceptions. And an actively managed ETF often has a significantly higher expense ratio than a passive fund.
  • Access to complex derivatives – Trading derivatives requires specialised trading accounts, which aren’t always easy to access, especially when it comes to investing with leverage. Through an ETF, investors can gain exposure to these derivatives indirectly.

What are the disadvantages of ETFs?

Investing in exchange-traded funds does have some drawbacks. Even the most well-run funds come with a few caveats investors need to consider.

  • Tracking errors – ETFs charge annual management fees, which can create significant tracking errors between the portfolio and the underlying benchmark over time. In extreme cases, this can lead to the fund’s performance being significantly different from its benchmark.
  • Limited liquidity – Some of the more specialised ETFs have a niche target audience, making it challenging to match buyers and sellers. This can lead to a significantly wider bid-ask spread compromising the return on investment.
  • Artificially inflated prices – Due to the rising popularity of open-ended ETFs, stocks or assets included in ETFs may have their valuations artificially inflated. Over long periods of time, this can create an asset bubble that can trigger significant volatility when a stock market crash or correction occurs.

The Bottom Line

Exchange-traded funds provide a cost-effective way for investors to gain exposure to diverse assets, industries, and financial derivatives.

The risk associated with these funds ultimately depends on their type. And investors seeking to diversify their portfolio with an ETF need to spend time researching which ones align best with their investment goals and risk tolerance.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Saima Naveed does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.

Written By

Saima Naveed

Saima spent the early days of her career advancing the finance office of a prominent manufacturing business. After taking a sabbatical, she decided to use her expert knowledge and apply it to the stock market. Now, 10 years later, she manages a substantial portfolio built using detailed and thorough analysis.

Outside The Money Cog, Saima is an avid supporter of empowering women in the workplace. She is currently working very closely with Women of Wonders Pakistan to help other women achieve their career goals.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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