Investing in ETFs: What they are and how they work

Everything you need to know about investing in ETFs:

Find out all the useful and necessary information on why we invest in ETFs. The topics covered in this guide are as follows:

What ETFs are
The advantages of ETFs
How Exchange Traded Funds work
How to choose funds
The costs involved in ETFs
Strategies for investing in ETFs
Frequently asked questions

Invest in ETFs with Moneyfarm:

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What are ETFs?

ETFs (Exchange Traded Funds) are passively managed investment funds. As with all funds, buying an ETF is like buying a selection of stocks, bonds or other investments. Investing in a fund is equivalent to pooling your resources with other investors and having a fund manager buy instruments on your behalf with the money. ETF performance is, broadly speaking, measured by combining the individual value of the stocks that make it up.

What are the advantages of ETFs?

1. Liquidity

As listed instruments, ETFs are highly liquid. This means that it is easy and straightforward to buy or sell shares without running the risk of seeing their value drop. 

4. Transparency

Transparency is baked into ETFs. It’s easy to get a full picture of the instruments that make up any given ETF and to evaluate them from multiple perspectives - from currency exposure to creditworthiness. 

2. Versatility

Thanks to the way they’re put together, ETFs mean that even smaller investors can access key indices without having to buy the securities that make up the basket individually. 

5. Security

The assets that make up ETFs are separated from that of the company that issues and manages them. So, even in the event of any bankruptcies, the funds are returned.

3. Efficiency

Passive management can make investing in ETFs efficient in its profitability. When you consider the fact that the management cost of ETFs rarely exceeds 0.5%, they start to look like cheap options.

6. Strategy

ETFs have made it easier and less time-consuming to put together multi-asset strategies that aim for medium and long-term growth by following trends in the market. They’re based on macroeconomic trends, broadly, an effective way to plan. 

How do ETFs work?

The thing that sets ETFs apart is they lend themselves to passive strategies. They’re designed to replicate the performance of a given index or the price of a given asset class - put simply, they allow you to follow that performance on a smaller scale. 

The FTSE Mib ETF will, for example, aim for the same daily result as the index it’s tracking. SImilarly, the gold price ETF will reflect changes of price in the gold market. To get this right, ETF managers buy shares of the securities of the reference indices - known as benchmarks - to build an asset with the same proportions. So, you end up with an investment that accurately reflects the value of the index it replicates. 

ETFs are different to active funds. Rather than giving a manager discretion to buy securities and chase returns, investing in an ETF means you can clearly see what you’ll be investing in ahead of time. The performance, then, depends on the fate of the index rather than necessarily the skill of the manager. 

How to invest in ETFs and which ETFs to choose

When choosing your ETFs, you should look at more than just the asset class they hold. There are, after all, multiple options for each single asset class. So, how do you choose between two different ETFs that reflect the same index? 

Here are some key factors to consider:

  • The number of assets in the fund, which affects its liquidity.
  • The replication method, physical or synthetic, favouring the former where possible.
  • The cost.
  • The reference currency.
  • The provider, or fund management house, favouring companies with a strong track record.
  • Premium or discount: sometimes, when there is particular demand for a product, you can create a premium or discount when selling your shares.

Our task, as managers, is to consider the impact of all of these factors when making the right decisions on behalf of our customers.

Our ETF portfolios

Is investing in ETFs worthwhile?

ETFs are practical and typically inexpensive tools. In recent years, they’ve boomed in terms of popularity, particularly while the ability of more active managers to consistently outperform the benchmark has been questioned.

ETFs are publicly traded instruments and ETF shares can be bought and sold at any time, just as if they were ordinary equities or bonds.

Why invest in ETFs?

Unlike most active mutual funds, ETFs are bought and sold on the exchange. To give you an idea of the size of the market, around 7,600 ETFs are listed globally. What this means for investors is greater flexibility and all the guarantees that come with investing in a regulated market.

Investing in ETFs allows you to:

Diversify your investment

Diversification has become an absolute must for any investor that wants to mitigate the risk in their investments. Building a diversified portfolio was traditionally expensive and complex, because it involved buying a lot of stocks. Now, in a single instrument, ETFs represent simple and effective diversification.

Low costs

ETFs reduce investment management costs. Thanks to their structure, wealth managers are able to optimise buying and selling, lowering the overall management costs incurred. There are, however, some potential limitations to bear in mind when investing in ETFs. Some argue, for example, that while passive investments have an advantage in healthy markets, they pay a premium in the event of market downturn.

Our strategy for investing in ETFs

Diversification through ETFs

The portfolios we build for our clients are made up exclusively of ETFs. We firmly believe that ETFs are the best choice for investors who want to keep costs down without sacrificing diversification. By purchasing just a few instruments, ETFs allow us to create portfolios that invest safely and effectively across all the key asset classes and geographies. Our Asset Allocation team, in addition to selecting the ETFs initially, evaluates the strategy on a regular basis to ensure that we keep pace with developments in the markets. Our costs associated with our wealth management process is about half that of traditional managers.

How we choose the right ETFs

When you invest, the first thing you have to establish is your goals and your attitude to risk. At Moneyfarm, we ask a series of questions to determine these factors for each individual investor, which is then evaluated by our consultants. The process helps us make investment decisions around our investors’ goals. We recommend completing the profiling questionnaire even if you’re just curious - it takes around 20 minutes and is free from obligation. We also offer free, independent advice on your existing investments.

FAQs on Exchange Traded Funds

Do you use smart beta ETFs?
What are physically replicated and synthetically replicated ETFs?
Do commodity ETFs exist, such as gold and oil?
What is the taxation on ETFs?
Are ETFs secure?
How do you select ETFs?
Why do you use ETFs?
What is an ETF?
Do ETFs come with any charges?

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