Understanding exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) are investment funds that trade on stock exchanges like stocks. ETFs are becoming a more popular way to invest. In the UK alone, over £300 billion is invested in ETFs listed on stock exchanges. But many investors may not fully understand how ETFs work, their pros and cons, or how to choose the right ETF for their investment goals. In this article, we'll explain in detail what ETFs are, how they work, their pros and cons, and how to choose the right one.

What do ETFs mean?

ETFs are investment funds that are traded on stock exchanges like regular shares. They are passive investment funds that follow an index's performance or a basket of assets. ETFs, give investors access to various assets, such as stocks, bonds, commodities, or currencies. They also give investors access to a whole market or a specific sector, industry, or region.

ETFs are often seen as a mix between stocks and mutual funds. ETFs are like mutual funds in that they pool the money of many investors and invest it in a wide range of assets. But unlike mutual funds, ETFs trade on an exchange and have prices that change throughout the day, like stocks.

Buying ETFs

Buying ETFs in the UK is easy and can be done in several ways. In this part, we'll talk about some of the most common ways people buy ETFs in the UK.

Online brokers:

An online broker is one of the easiest and most popular ways to buy ETFs in the UK. Several online brokers, such as Hargreaves Lansdown, IG, Interactive Brokers, and E*TRADE, allow buying and selling of ETFs. These brokers usually offer ETFs from different companies and let you buy and sell ETFs in real time. To buy ETFs through an online broker, you must set up an account, give some personal information, and transfer money into your trading account.

Robo-advisors:

A robo-advisor is another way for people in the UK to buy ETFs. Robo-advisors are digital platforms that use algorithms and artificial intelligence to give you investment advice and manage your portfolio. Some robo-advisors, like Rosecut and Wealthify, include ETFs in their portfolios of investments. To buy ETFs through a robo-advisor, you must sign up for an account, answer some questions about your investment goals and risk tolerance, and transfer money into your account.

Direct from ETF providers:

You can also go straight to the ETF provider in the UK to buy ETFs. Investors can buy ETFs directly from the websites of most major ETF providers, like BlackRock, Vanguard, and iShares. This method can be helpful because you don't have to go through a broker or advisor to buy or sell ETFs. But it might not be the most affordable choice because some providers may charge more for direct purchases.

Through a financial advisor:

You can also buy ETFs through a financial advisor if you prefer to work with one. Financial advisors can tell you which ETFs to buy based on your investment goals, how comfortable you are with risk, etc. They can also help you keep track of your investments and manage your portfolio. Working with a financial advisor, on the other hand, can cost more than other options because advisors usually charge for their services.

After deciding how to buy ETFs, the next step is to choose which ones to buy. In the UK, there are a lot of different ETFs that cover different asset classes, industries, and countries. In the UK, some of the most popular ETFs are:

FTSE 100 ETFs:

These ETFs follow the performance of the FTSE 100 index, which comprises the 100 biggest companies listed on the London Stock Exchange. FTSE 100 ETFs give investors access to a wide range of UK companies, such as banks, energy companies, and companies that make consumer goods.

S&P 500 ETFs:

The S&P 500 index comprises 500 large-cap US companies, and these ETFs track how that index does. Some of the world's biggest and most well-known companies, like Apple, Microsoft, and Amazon, are in the S&P 500 ETFs.

Emerging markets ETFs:

These ETFs buy stocks and bonds from countries like China, Brazil, and India that are still developing. Emerging markets exchange-traded funds (ETFs) can give investors access to economies that are growing faster than those in developed countries, but they also come with higher risks.

Bond ETFs:

These ETFs buy fixed-income securities like government, corporate, and high-yield bonds. Bond exchange-traded funds (ETFs) can give you income and help you diversify your portfolio, but they also come with some risks, like interest rate and credit risk.

Sector ETFs

These exchange-traded funds (ETFs) focus on certain parts of the economy, like technology, healthcare, or energy. Sector ETFs can expose you to industries expected to do well but have higher risks and volatility.

ESG ETFs:

These ETFs put their money into companies that meet certain environmental, societal, and management criteria. ESG ETFs provide access to socially responsible and sustainable firms but may have different risks and returns than standard ETFs.

Commodity ETFs: 

Gold, silver, and oil are bought with these ETFs. Commodities' ETFs give you access to good commodities, but they also come with worries about geopolitics and the supply chain.

When choosing ETFs, you should consider your investment goals, how comfortable you are with risk, and how long you want to hold on to them. Think about ETF fees. Your broker or adviser may charge you fees for trading, expenses, and other things.

Tell your broker or financial advisor what ETFs you want to buy. The broker will usually ask you how many shares you want and at what price per share when you place an order. ETF prices change based on how the market is doing and how much supply and demand there is.

You can keep ETFs in your trading account or move them to a Self-Invested Personal Pension (SIPP) or Individual Savings Account (ISA) (SIPP). Putting ETFs in an ISA or SIPP may lower taxes and increase returns.

In conclusion, people in the UK can buy ETFs through internet brokers, robo-advisors, ETF providers, or financial advisors. Choose ETFs based on your investment objectives, risk tolerance, and cost. Move ETFs from your trading account to a personal investment account to maximize profits and minimize taxes.

Creation and Redemption of UK

Buying and selling ETFs is an important part of how they work. It helps them stay close to their net asset value (NAV)and gives investors access to cash. ETFs in the UK are made and redeemed the same way as in other countries, with a few key steps.

Creation Process

An authorized participant (AP), typically a sizable bank with authorization from the ETF provider to create and market ETF shares, is where the creation of an ETF begins. The AP will buy a "basket" of securities from the market. These are usually the same securities that make up the benchmark index of the ETF. The AP will then give the creation basket to the ETF provider in exchange for shares of the ETF.

The ETF's net asset value (NAV) determines the number of shares to be made when creating the shares. If the ETF's NAV is £100 million and the creation basket price is £99 million. The AP will acquire shares equivalent to £99 million's assets, and the ETF will retain £1 million in cash.

Redemption Process

The redemption process is a lot like the opposite of the creation process. An authorized participant (AP) can return shares of an ETF to the ETF provider in exchange for a redemption basket of securities. Most of the time, the redemption basket is the same as the creation basket. Its purpose is to give the AP the underlying securities that make up the benchmark index of the ETF.

The ETF's net asset value (NAV) at the time of redemption also affects how many shares are redeemed.

If the ETF's NAV is £100 million and the redemption basket's price is £101 million. The AP will get shares worth £100 million in securities, and the ETF will pay the additional £1 million in cash.

ETF-related Policies and Regulations

The UK Financial Conduct Authority (FCA) makes ETF rules and policies. The FCA's job is to ensure that ETFs are clear, well-regulated, and fair to investors. The FCA has set up several rules and policies for ETFs in the UK.

·       Disclosure requirements:

ETF providers must tell investors everything they need to know about the ETF's investment strategy, risks, fees, and other important facts. Most of the time, you can find this information in the ETF's prospectus and fact sheet, which you can find on the provider's website or elsewhere.

·       Asset segregation:

ETF providers must keep ETF assets distinct from theirs and other funds. Liquidating the underlying assets to compensate investors protects them against ETF provider bankruptcy.

·       Calculating the net asset value (NAV):

ETF providers must figure out the NAV of the ETF daily and share it with investors. This helps investors determine what the ETF is worth and what risks and gains it might have.

·       Market making:

ETF providers must have a market maker in place to ensure that the ETF's underlying assets have enough liquidity. This helps ensure that the ETF can be bought and sold at a fair price and that investors can get out of their positions if needed.

·       Reporting requirements:

ETF providers must give investors regular updates on the performance of the ETF and any changes to the investment strategy, as well as annual and semi-annual reports.

·       Securities

Certain types of securities cannot be invested in by ETF providers, such as those that are not easily sold, made by the provider or its affiliates, or not traded on a public market.

·       Use of derivatives:

When ETF providers use derivatives to manage an ETF, they must follow certain rules. This includes ensuring that the use of derivatives fits with the investment goals of the ETF and that risks are handled properly.

·       Short selling:

ETF providers can sell securities they don't own, but they have to do it in a way that fits the ETF's investment strategy and the FCA's short-selling rules.

·       Stewardship:

ETF providers are expected to be good stewards of the assets that make up the ETF. They should use their voting rights and work with companies to promote good governance and environmental, social, and governance (ESG) practices.

The FCA has implemented several policies and rules to ensure that ETFs are well-regulated, clear, and fair to investors. By following these rules, ETF providers can help investors make smart investment decisions and manage their risks well.

Advantages of the process of creation and redemption

The creation and redemption processes help investors and the ETF industry in several ways. These things are:

Liquidity:

Even when the market is volatile, ETFs trade close to their NAV because of the way they are made and sold. When an ETF's price is higher or lower than its NAV, APs can buy or sell shares to help bring the price back to where it should be.

Spend less:

By making it less likely that the ETF provider will have to buy and sell securities on the market, the creation and redemption process can help keep ETF costs low. APs can help the ETF provider avoid trading costs and market impact by simultaneously buying and selling many shares.

Flexibility:

How ETFs are created and sold enables investors to buy and sell them without affecting the market. ETFs are tradable throughout the trading day, while traditional mutual funds are only tradeable at the end of the trading day.

Tax:

ETFs' creation/redemption processes save on capital gains tax for managing underlying securities. ETFs' buying/selling process provides liquidity, lower costs, flexibility, and tax efficiency. Knowing how ETFs are created/sold helps make better investment decisions as part of a larger strategy.

Difference between ETFs and regular funds/shares

ETFs are a type of investment vehicle similar to shares and traditional mutual funds in some ways but also have some key differences. Shares, also called stocks or equities, are pieces of a company. When you buy a share, you get a small piece of the company and a right to a share of its profits and losses. Shares can be bought and sold on stock exchanges, and their prices change depending on the company's performance.

Traditional mutual funds pool money to buy stocks, bonds, and other securities, managed by a professional. Investors trade based on NAV at day end.

Here are some of the most important ways in which ETFs are different from shares or traditional mutual funds:

Flexibility in trading:

Shares are tradable all day, traditional funds only at NAV. Like mutual funds, ETFs are like shares, but prices are based on assets.

Diversification:

Mutual funds and exchange-traded funds (ETFs) enable you to invest in various assets, while shares let you own a single firm. Unlike ETFs, mutual funds are actively managed and have higher costs.

Transparency:

Shares and mutual funds don't have to tell investors much about the underlying assets and portfolio holdings, but ETFs do. This is because they must tell investors daily what their portfolio holdings are.

Costs:

Shares can have transaction and ongoing management fees, while mutual funds and ETFs usually have ongoing management fees. On the other hand, ETFs tend to have lower fees than mutual funds because they are managed automatically and have lower operating costs.

Tax Efficiency:

A capital gain or loss can be made when shares are bought and sold. Capital gains or losses can also be made when assets are bought and sold within a mutual fund or ETF. Conversely, ETFs are usually better for taxes than mutual funds because they have less turnover and can be traded without creating taxable events.

In short, ETFs have some of the same benefits as shares and traditional mutual funds, such as the ability to trade quickly, diversification, low costs, and tax efficiency. But they also have unique features that set them apart from shares and traditional mutual funds. For example, intraday trading, passive management, and daily portfolio disclosures are all things that make them different. When deciding if ETFs are a good choice for their portfolio, investors should consider their investment goals, how much risk they are willing to take, and other factors.

The pros of ETFs

Diversification:

ETFs are a simple and cheap way for investors to diversify their portfolios. With a single ETF, investors can get exposure to a wide range of assets, which can help reduce risk and increase returns.

Transparency:

ETFs are very clear because they list their holdings daily, so investors can see exactly what they are investing in.

Low prices:

ETFs are passively managed and don't need expensive research or analysis, so they have lower management fees and costs than traditional mutual funds.

Liquidity:

ETFs trade on a stock exchange like stocks do. This means that investors can buy or sell them at the current market price at any time during the trading day.

Flexibility:

ETFs can be used for both short-term trading and long-term investing. They can also be used to gain exposure to certain sectors, regions, or asset classes.

How well taxes work:

ETFs are tax-efficient because they give out fewer capital gains than mutual funds. This can help investors save money on taxes.

Disadvantages of ETFs

Tracking mistake:

Due to fees, expenses, and rebalancing, an ETF's performance may not be the same as the performance of the index it tracks.

Liquidity risk:

Some ETFs may have few trades or not be very liquid, making it hard to buy or sell at the price you want.

Market risk:

ETFs are subject to market risk, meaning their value can change based on how the index or asset class they track changes.

Complexity:

Some ETFs may be hard to understand because they have many layers of leverage or derivatives. This can make them riskier and harder to understand.

Risk of concentration:

Some ETFs may have a lot of investments in just one sector, industry, or region, making them riskier if that sector or region goes through a bad time.

Management risk:

Even though ETFs are passively managed, they still need to be managed somehow, which can lead to mistakes or poor management.

How to pick the best ETF?

It can be hard to pick the right ETF because there are so many to choose from, and each may have different goals, strategies, and risks. Here are some important things to think about when choosing an ETF:

The goal of an investment:

The first step in picking an ETF is deciding what you want to get from your investment. Do you want to reach a certain market, industry, or region? Do you want to make money or grow? Once you know what you want, you can narrow your choices to ETFs to help you reach your goal.

Tracking the index:

ETFs are made to track the performance of an underlying index, so it is important to understand the index that the ETF is tracking. Is it a broad index, like the FTSE 100 or the S&P 500, or a specialized index, like a technology or energy index? If you understand the index, you can determine how risky the ETF is and how much money it could make.

Charges and costs:

ETFs have management fees and other costs, which can differ from one ETF to the next. Compare the fees and costs of different ETFs to ensure you get a good return on your investment.

Liquidity:

Some ETFs may have few trades or not be very liquid, making it hard to buy or sell at the price you want. Before investing in an ETF, you should look at how liquid it is to ensure you can easily get in and out of your position.

History of performance:

Even though an ETF's past performance isn't a guarantee of how it will do in the future, it's still important to look at it. How is the ETF compared to its benchmark and other ETFs in the same asset class? Has it gone through big changes or tracking mistakes?

Risk:

Every investment comes with some risk, and knowing the risks is important before making an ETF investment. Think about the ETF's concentration risk, market risk, tracking error, and any risks specific to the assets or strategy it is based on.

Conclusion

ETFs are a popular way to invest for people who want to get exposure to a wide range of assets easily and affordably. They offer the diversification, openness, low costs, liquidity, and tax efficiency but also have problems that are hard to understand, like tracking errors and liquidity risk. To pick the right ETF, investors should consider their investment goals, how closely it follows an index, fees and expenses, liquidity, past performance, and risk. By knowing what ETFs are and how to choose the right one, investors can benefit from this type of investment while minimizing the risks.