I wish I knew what an ETF was, but I’m too embarrassed to ask

Many investors use ETFs, or exchange-traded funds, as part of a passive investment strategy. But what exactly is an ETF?

The acronym ETF stands for exchange-traded fund. And that pretty much sums up what it is. It’s a fund that is bought and sold on a stock exchange.

Most ETFs are passive funds. In other words, they aim to track the performance of a specific asset or stockmarket index, such as the FTSE 100 in the UK, or the S&P 500 in the US.

There are two main ways in which ETFs do this. Physical ETFs simply own the same assets as the index they are aiming to track. So a physical FTSE 100 tracker would own all the shares in the FTSE 100 in the same proportion as in the underlying index.

Synthetic ETFs instead use financial instruments called derivatives to copy the returns on the underlying market, without having to own the physical assets at all. Synthetic ETFs still have to be backed by collateral, but the use of derivatives introduces counterparty risk. That is, the danger – however small – that the investment bank which underwrites the derivative might be unable to pay out.

ETFs are not limited to tracking stock indexes. There are ETFs and ETF-style products available to track the price of anything from individual commodities to bond indexes to currency markets to “themes” such as robotics and AI, or cannabis stocks.

If you are considering investing in an ETF, you can get an idea of how efficiently it tracks the underlying asset by looking at the “tracking error”, which simply measures the gap between the return on the ETF and the return that it’s supposed to be matching. The narrower, the better. You should also – as always - look at how much the ETF costs in terms of annual fees and trading costs.

So why might you use an ETF rather than a traditional open-ended fund, or an investment trust? The big difference between an ETF and an open-ended fund is that an ETF is listed, and so can be bought or sold throughout the trading day.

The big difference between ETFs and investment trusts – or closed-ended funds – is that while both are listed on stock exchanges, an ETF should – except in exceptional circumstances – always track the value of its underlying assets very closely. An investment trust, by contrast, can trade at a premium or a discount to the value of its underlying portfolio.

To find out more about ETFs, subscribe to MoneyWeek magazine.

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