ETFs are great investments for the long term too

Exchange-traded funds (ETFs) have become highly popular in recent years: at the end of May, ETFs around the world held almost $3trn in assets, up from around $400bn a decade ago. But for many investors, the difference between ETFs, open-end funds (often referred to as unit trusts) and investment trusts is not clear. So what makes ETFs different and why might you choose to use them?

An ETF is a type of fund that is traded on a stock exchange, and can be bought and sold through a stockbroker, just like a share. The price of an ETF varies throughout the trading day in line with the value of the market it tracks so if the FTSE 100 drops 3%, the price of the ETF should drop by the same amount.

This makes ETFs different from other types of funds. Investment trusts also trade on an exchange, but unlike ETFs their share prices don't have to track their underlying investments they can trade at a premium or discount to the value of their assets.

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Conversely, open-end funds are traded at a price directly linked to the value of their assets, but they aren't listed on an exchange. Instead, they are bought directly from the fund manager or through a fund supermarket, and trades are usually carried out just once a day.

ETFs are almost always passive funds, meaning that they try to match an index such as the FTSE 100, rather than beat it. Investment trusts are almost always active funds (they aim to beat the market). Open-end funds may be active or passive.

Many people think of ETFs as a tool for traders, because they are a simple and cost-effective way of trading into and out of a market very quickly. For example, if you believe Japanese stocks are likely to go up because of bullish economic news, you might buy an ETF that tracks Japan's Topix benchmark at the start of the trading, then sell it a couple of hours later when the market has moved. But they are also a useful tool for long-term investors, for two main reasons.

The first is that they are cheap: some ETFs based on the S&P 500 have annual expenses of less than 0.1% and even emerging-market ETFs can have expenses as low as 0.25%. That's far less than traditional active funds. And while active funds offer you the chance of beating the market rather than just matching it, the reality is that the average fund manager underperforms the market.

So unless you believe that you are particularly good at spotting managers who will outperform, your returns are likely to be better on average with cheap passive funds.

ETFs are not the only option for cheap trackers: traditional index funds can be very cheap as well. However, the range of ETFs available is growing much more rapidly. For example, if you want to track a specific emerging market, there'll probably be an ETF for it, while there often won't be a traditional index fund. This means that ETFs can offer many more options for tailoring a passive portfolio for your own requirements.

Four common questions

What's the difference between physical and synthetic ETFs?

Do ETFs always track their indices perfectly?The performance of an ETF will differ slightly from its index this is known as tracking difference. Costs play a major part in determining how big the tracking difference is. But discrepancies caused by the ETF's investments not matching the index exactly can also be important. In particular, some physical ETFs use an approach called optimisation.

This means they don't buy all the securities in the index, but hold a smaller selection that should mirror the performance of the index as closely as possible. Optimisation can be a more cost-effective way of tracking illiquid securities, such as corporate bonds or emerging-market stocks. But if the optimisation isn't done well, the ETF may not track its index as closely as it should.

What are the risks of ETFs?Apart from the risk that the underlying investments won't perform as you hope, there is also a risk that counterparties that the ETF relies upon won't meet their obligations. Many physical ETFs lend out securities for example, to short sellers in order to earn additional revenue (other funds often do this as well it's not just the case for ETFs). These securities may not be returned if the borrower goes bust.

Synthetic ETFs may not receive the payments they are due under their swap contract if the counterparty to the contract fails. However, ETFs can minimise these risks by taking collateral from their counterparties (and for synthetic ETFs in most countries, there are strict rules on this). For ETFs run by major fund managers, these risks are very small in practice, although not nonexistent.

Can the price of an ETF differ from its value?An ETF's price is kept in line with the value of its investments by institutional investors known as authorised participants, who trade directly with the ETF. This mechanism can break down during periods of severe market stress, so investors who are trying to sell during a panic may not get a fair price.