How to invest using ETFs: a beginner's guide

Our beginner’s guide runs through the basics of exchange-traded funds (ETFs) that investors need to get to grips with.

An increasing focus on the cost of investing and disillusionment with the performance of active managers, plus greater choice, have buoyed the popularity of exchange-traded funds (ETFs).

Our beginner’s guide runs through the basics that investors need to get to grips with.

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What are active and passive funds?

An active fund has a fund manager and a team of researchers who select the shares they believe will perform best. The idea is that the skill of the fund manager, combined with their research capabilities, should allow them to identify the shares that are likely to excel. This can include smoothly navigating the economic backdrop, such as changing inflation and interest rates.

To measure their performance, funds often use a stock market index as a benchmark. This benchmark is chosen to be comparable to the portfolio of stocks that the fund manager puts together. For example, a fund manager who buys UK shares may use the FTSE All-Share index as their benchmark.

The return of a fund over a given period is then measured against the benchmark. A fund manager who provides returns higher than the benchmark is said to be “outperforming”, while those providing returns lower than the benchmark are said to be underperforming.

With active funds there’s no guarantees the investments chosen will outperform the benchmark.

Active funds are generally more expensive as the fund manager’s salary and his or her resources cost money. A typical active fund will charge somewhere between 0.75% and 1% a year (known as the ongoing charges figure), which is higher than most passive funds, where 0.1% to 0.2% a year is typical.

Due to the impact of fees, passive funds tend to outperform active funds on average.

In contrast to active funds, passive funds simply hold all the stocks in an index. Rather than trying to buy the best shares, passive funds aim to replicate the performance of an index.

A simple way to understand the difference between active and passive is to think of active managers as trying to uncover needles (good shares) in a haystack (the market). Passive funds, meanwhile, buy the whole haystack, knowing that the needles are in there somewhere.

• Watch our Fundamentals video: what is a passive fund and is this the best way to invest?
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What are ETFs?

ETF stands for exchange-traded fund. Invented in the early 1990s, ETFs are investment funds that can be traded on stock exchanges in the same way equities are.

ETFs started their life as a way to track a broad basket of stocks using an index (explained below), such as the S&P 500, Dow Jones Industrial Average or FTSE 100.

Investors still mostly use ETFs to track these indices. However, over the years, ETFs have become more sophisticated. They now offer the ability to track a basket of a wide range of other asset classes such as bonds, property, currencies, or commodities (such as gold and oil). They can also be used to track more niche baskets of stocks.

What is an index?

An index is a basket of assets, such as stocks, bonds, or commodities, chosen to represent the performance of a market or an asset class. So, for example, the first index was created by Charles Dow in 1896, and known as the Dow Jones Industrial Average. At the time, it included the 12 largest companies in the US and was designed to give an idea of the general direction of the US stock market. The index is still around today and includes 30 stocks.

Since then, indices have expanded and become more sophisticated, but broadly serve the same purpose. So, the S&P 500, composed of 500 large US stocks, is primarily used as the gauge of the health and direction of the overall US stock market.

An index can also be used to gauge the performance of a particular type of stock, based on the criteria used to include stocks in the index. For example, the Nasdaq Composite index is taken as a gauge for the general health of US technology stocks.

Usually, the goal of an ETF will be to provide a portfolio that mirrors an index, thereby providing the performance of that index (minus its fees).

What’s the difference between ETFs and index funds?

Passive funds come in two forms: index funds and exchange-traded funds (ETFs). The core difference is that unlike index funds, ETFs can be traded throughout the day on the stock market, much like individual stocks. For long-term investors, the difference is not important.

Types of exchange-traded funds (ETFs)

Most ETFs track long-established equity indices such as the S&P 500 or FTSE 100. There are also those that track bond market indices, a basket of commodities, baskets of currencies and property.

But in recent years, ETFs have become more niche. There are now millions of different indices with all sorts of different rules to decide which stocks or assets are included.

For example, some ETFs track certain sectors within a wider index, such as financial stocks. Other ETFs track certain themes. For example, a popular theme in recent years has been cloud computing. A cloud computing ‘thematic’ ETF will usually track a cloud computing index, which will comprise companies deemed to be involved in cloud computing.

Another ETF option are ETFs using “smart beta” or “factor” strategies, in industry jargon. These ETFs do not track shares by market capitalisation, as a fund tracking, say, the FTSE 100 index would. Instead, they track an index which screens for stocks that possess certain characteristics. For example, some smart beta funds follow a basket of companies that are reliable dividend payers, while others target the highest-yielding shares on a particular index.

Main advantages and disadvantages of investing in ETFs

The primary advantage of ETFs is that they are low cost. Thanks to their unique structure and because they (usually) have no active portfolio manager, they are much cheaper for investment houses to run. As a result, investors are charged less. Some popular ETFs charge as little as 0.05%, which works out at £5 on a £10,000 investment.

There is no stamp duty to pay when you buy an ETF. Investors, however, need to look at the spread between the buying and selling price, although for most ETFs these are very small.

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Another attraction is their simplicity. Investors who buy an ETF opt to simply ‘buy the market’ and their returns will mirror how the index performs, minus fees.

ETFs are also very liquid, so you won't have problems buying and selling usually. On top of this, unlike unit trusts, which are priced once a day, ETFs are priced throughout the day, so you get the price you see immediately.

Another key advantage of ETFs is that they offer access to previously hard to reach parts of the market for private investors. Prior to the invention of ETFs, investors would have struggled to find a way to gain exposure directly to the price of oil or easily track a basket of value stocks.

The main disadvantage is that an ETF, by design, will not outperform the index it is tracking (usually). Actively managed funds, run by fund managers, aim to provide outperformance, but there are no guarantees this will be achieved.

Are ETFs good for beginners?

Beginner investors should consider using an ETF to gain exposure to major stock market indices. Broad exposure to main markets such as the S&P 500 or FTSE All-Share is viewed as a sensible core part of any beginner investor’s portfolio. ETFs provide a cheap and easy way to do this. ETFs are listed on the London Stock Exchange, so you buy them through an online investment platform such as interactive investor.

Physical or synthetic?

It is important to be aware of how the ETF is structured in aiming to replicate the performance of an index. There are two approaches: physical and synthetic.

A physical ETF buys the shares of the underlying index it is supposed to mirror. This means that if you use a Vanguard ETF to track the FTSE 100, Vanguard buys the shares held in the index in question. Vanguard is the legal owner of the shares and is afforded all the usual rights of a shareholder, such as being able to vote at board meetings.

In contrast, a synthetic ETF is designed to replicate the return of the underlying index, just like a physical ETF, but without owning the shares of the index in question. Instead of buying the shares, the index is replicated through so-called swap transactions. This means that the ETF provider enters into an agreement with a financial institution that is then obliged to deliver the index return.

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