Updated August 2018
Exchange-traded funds (ETF) are investment funds that are bought and sold on a stock exchange in the same way as you would trade normal shares. Unlike investment trusts, which are also traded on exchanges, ETFs are mostly passive investments. This means their aim is to track the performance of a particular market, rather than to try to beat it, as an active fund does.
ETFs are available on a wide range of indices, sectors, investment themes and commodities (and because of their huge and rapidly growing popularity, index providers are constantly launching new indices for them to track). Given their largely passive structure, ETFs tend to have lower fees than most traditional active funds, and rampant competition is driving the price ever lower.
ETFs come in two types: “physical” and “synthetic”. A physical ETF invests in the same assets that it’s supposed to track. For example, a FTSE 100 ETF will invest in FTSE 100 stocks in proportion to their weighting in the index itself. A synthetic ETF instead agrees a “swap” with a third party – typically an investment bank – which agrees to pay the ETF a return based on the performance of the index.
Many investors prefer physical ETFs because they view them as less vulnerable to unexpected risks, such as the possibility that the counterparty to the swap won’t pay out. However, synthetic ETFs based in the UK and Europe must hold collateral to back these swaps, which means the risks should be limited.
Physical ETFs are arguably simpler and more transparent, but there are situations in which synthetic ETFs may be superior. For example, when investing in certain emerging markets, some of which restrict foreign investment and share ownership, a swap-based structure may be more cost-effective than investing directly in the underlying shares.
• Watch Tim Bennett’s video tutorial: What is an exchange-traded fund?