WHAT IS
AN ETF?

Exchange-traded funds (ETFs) have become one of the most popular investment vehicles for investors seeking diversified exposure to various markets. This guide will discuss the fundamentals of ETFs: what they are, how they work, and the pros and cons of investing in them.

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ETFs are a basket of investments such as shares, bonds, or commodities. Their unique structure combines the diversification benefits typically associated with traditional funds with the flexibility and transparency of trading individual securities throughout the market day.

Understanding ETF Basics

An ETF holds a collection of assets and aims to track the performance of a specific benchmark, index, or investment theme. Unlike buying individual shares, one ETF purchase provides instant exposure to tens, hundreds, or even thousands of underlying holdings.

Most ETFs are designed to track something specific, with popular examples including:

• Stock indices such as the FTSE 100 Index and S&P 500 Index.
• A particular sector such as technology, or healthcare.
• Commodities such as gold. 

The ETF provider manages the fund to ensure it follows its stated objective, adjusting holdings as needed to maintain alignment with the benchmark.

The beauty of ETFs lies in their simplicity and accessibility. Rather than researching and purchasing dozens of individual investments, investors can gain broad market exposure through a single trade.

This makes ETFs particularly appealing for those new to investing or anyone seeking efficient diversification.

How ETFs Work

ETFs track an index using a unique creation and redemption process that keeps the ETF’s market price close to the value of the underlying index it is intended to track. Authorised industry participants act as fund managers and create or redeem ETF shares in large blocks, helping maintain price efficiency.

Tracking vs Holding Assets

When an ETF tracks an index, it typically means the fund either holds the actual securities in that index (physical replication) or uses financial instruments to replicate the index’s performance (synthetic replication). 

In the case of physical replications, a FTSE 100 Index ETF would actually own shares in the 100 companies that make up the index, weighted according to their index representation.

Understanding NAV and Market Price

The Net Asset Value (NAV) represents the per-share value of all holdings in the ETF. During trading hours, ETFs trade at market prices that may slightly differ from NAV due to supply and demand. 

The difference between NAV and market price is usually minimal for liquid ETFs, but can be more pronounced during volatile markets or for less-traded funds.

Tracking Difference Explained

Tracking difference occurs when an ETF’s returns don’t perfectly match its benchmark. This can happen for a variety of reasons, including: 

• Ongoing charges reducing net returns.
• Trading costs from rebalancing of holdings.
• The practical challenges of exactly replicating an index.

ETF vs Mutual Fund: Key Differences

ETFs and mutual funds both offer pooled investment structures, but they operate quite differently. ETFs trade throughout the day with real-time pricing like shares, while most mutual funds price once daily after markets close. The table below compares some other features of both types of fund:

Feature	ETFs	Mutual Funds
Pricing timing	Continuous during market hours	Typically once daily after close
How it trades	On stock exchange like shares	Direct with fund company
Common fee types	Ongoing charge plus trading spreads	Annual management charge
Holdings transparency	Usually disclosed daily	Often disclosed monthly or quarterly

The intraday trading capability of ETFs provides flexibility that mutual funds cannot match. Investors using ETFs can:

• React to market events immediately
• Use limit orders and stop-losses to control trade execution prices
• See exactly what price they’re paying when they trade.

Cost Considerations

ETFs often feature lower ongoing charges than actively managed mutual funds, this is because ETFs track the market rather than appoint expert teams who are paid to try and beat the market.

The way that operational costs are applied also differ. 

• When buying an ETF, you’ll pay the offer price and receive the bid price when selling – this bid-ask spread represents an implicit cost. 
• Mutual funds in comparison may have initial charges or exit fees but buy and sell trades are booked at the NAV price without spreads.

Types of ETFs

ETFs cover virtually every investable market segment, from broad indices to specific themes. The table below outlines some of the main categories and illustrates the range of ETFs on offer to investors.

Type	What They Track	Example Focus
Broad Market/Index	Major stock indices	FTSE All-Share, S&P 500
Sector	Specific industries	Technology, healthcare, energy
Bond/Fixed Income	Government or corporate debt	UK gilts, investment-grade corporate bonds
Commodity	Physical goods or futures	Gold, oil, agricultural products
Thematic	Specific trends or themes	Clean energy, artificial intelligence

Each category serves different portfolio needs. 

• Broad market ETFs provide core exposure to entire markets
• Sector and thematic ETFs allow targeted positions in specific areas. 
• Bond ETFs offer income potential and typically lower volatility than equity options.

Case Study: ETF Exposure

Consider three ETF investments of $1,000 each. 

• The Vanguard S&P 500 ETF (VOO) spreads invested capital across 500 of the largest multinational US companies in various sectors. 
• Investing in the Global X Copper Miners ETF (COPX) would provide exposure to high-beta stocks of global companies involved in copper mining, exploration, and refining.
• While the ARK 21Shares Bitcoin ETF (ARKB) seeks to track the performance of bitcoin, as measured by the performance of the CME CF Bitcoin Reference Rate.

Each of these ETFs have considerably different investment profiles and offer different opportunities and risks for investors.

ETF Costs and Fees

ETF costs include both explicit fees like the ongoing management fee charge and implicit costs such as trading spreads. Both of these charges need to be factored into overall returns.

Ongoing Charges

The Ongoing Charge Figure (OCF), which is also referred to as the Total Expense Ratio (TER) represents the annual fee for managing the ETF. For example, an ETF with a 0.20% ongoing charge costs approximately $2 per year for every $1,000 invested. 

This fee is deducted from the fund’s assets, not charged directly to your account, and the total expense ratio will reflect the scale of work the fund manager is required to carry out. 

The three ETFs found in our exposure case study have the following expense ratios:

• Vanguard S&P 500 ETF (VOO): 0.03%
• Global X Copper Miners ETF (COPX): 0.65%
• ARK 21Shares Bitcoin ETF (ARKB): 0.21%

Trading Costs

Beyond the ongoing charge, investors face trading costs:

• Bid-ask spread: The difference between buying and selling prices
• Brokerage fees: Some platforms charge per trade (though many now offer commission-free ETF trading)
• Currency conversion: For ETFs priced in foreign currencies

Common ETF Risks

Market risk, the chance that the value of the assets you hold will fall affects all ETFs, while other types of risks vary by fund type and structure.

Market Risk

ETF values fluctuate in line with their underlying holdings. An equity ETF falls when stock markets decline, while bond ETF values typically drop when interest rates rise. The structure of an ETF does not eliminate market risk; it is an inherent feature of all investing.

Liquidity Risk

Although ETFs trade on exchanges, liquidity varies significantly. Popular ETFs tracking major indices typically offer tight spreads and easy trading. Niche or newly launched ETFs may have wider spreads and less trading volume, potentially increasing transaction costs.

Tracking Error Risk

ETFs which don’t effectively track the index they are supposed to will generate returns which are different from what a subscribing investor was expecting. While tracking errors are typically not materially significant, they are hard to monitor and may come as a surprise to investors who assume an ETF will track effectively.

Tracking error can result from the fund’s replication method, securities lending activities, or management decisions.

How to Get Started Investing in ETFs

The first step to investing in ETFs is to assess your goals and determine your risk tolerance. Before creating a plan, it’s important to do thorough research so that you can make well-informed decisions on the best investments for you. Here are a few tips to getting started: 

• Stay informed. Keeping up with industry news and trends can help you to identify a sector or theme you want to invest in. 
• Understand the fees associated with potential investments. Remember, not all brokers or trading platforms charge fees for ETF trading.
• Track the past performance of the ETF you’re researching and decide if it aligns with your personal investing goals and values. 
• Consider what the ETF is tracking. Is it following the broader market or a specific industry? 

Ultimately, creating a balanced portfolio of investments combined with an understanding of your goals will help you to select the ETF strategy most closely aligned to your investment aims.

Final thoughts

ETFs combine the diversification of traditional funds with the trading flexibility of individual shares, making them accessible tools for building investment portfolios.

While they are not completely without risk, the functionality of ETFs does offer potential advantages and given the wide selection available it is likely you can find one to match your specific investment goals. 

Visit the eToro Academy to learn more about ETF investing.

FAQs

How does an ETF differ from a mutual fund?

The major differences between ETFs and mutual funds relates to their pricing, valuation and trading mechanisms. Mutual funds are valued once per day and investors need to give prior notice if they want to buy or sell units of the fund at that valuation price. ETFs are valued in real-time and can be bought and sold at any time that the exchange on which they are listed is open.

Do ETFs pay dividends like individual stocks?

Stock ETFs typically distribute dividends to investors. If a stock which forms part of an ETF pays a dividend, this is passed on to the owner of the ETF position. It is important to check the T&Cs of any fund you are investing in to ensure you are aware of how corporate actions such as dividends are treated.

Should beginners invest in ETFs?

Exchange-traded funds are often considered a good option for less experienced traders who may otherwise struggle to pick individual stocks and assets to invest in. ETFs are a cost-effective solution for portfolio diversification, but they are not without risks. New investors should ensure they understand how ETFs work before committing real funds to a trade.

What are the most popular ETFs?

There are a range of ETFs available across a variety of asset classes. For example, the price of the SPDR S&P 500 ETF corresponds with the price and yield of the S&P 500 Index, while the SPDR Gold ETF is the world’s largest physically-backed gold exchange-traded fund. These are two of the most popular ETFs, but there are plenty of options available to investors interested in the financial, real estate or healthcare sectors, to name but a few.

What are the alternatives to ETFs?

ETFs are just one way to invest. There are many assets similar to ETFs you could consider adding to your portfolio, depending on your risk tolerance and financial goals. This includes individual stocks, investment trusts, mutual funds and index funds.