What is an exchange traded fund (ETF)?
An ETF – meaning exchange traded fund – is an investment instrument that tracks the performance of an existing market or group of markets. The fund will either physically buy a basket of the assets they are tracking or use more complicated investments to mimic the movement of the underlying market.
ETFs are bought and sold on a stock exchange – in much the same way as stocks are traded. However, they do not grant the investor shareholder rights in the same way as traditional investing. For example, stock ETFs can pay dividends, but do not grant the holder voting rights. If you want to be an active shareholder, you should consider share dealing instead. Likewise, investing in a commodity-based ETF would not grant you physical ownership of the underlying asset.
It is important to remember that most ETFs are passive investments – that means they seek to emulate the returns of the underlying assets, not outperform the market. You can choose to trade ETFs via spread bets and CFDs, or invest via our share dealing service.
Find out more about how to take a position on ETFs or start trading now.
Popular ETFs to watch
- The iShares Core S&P 500 ETF tracks the S&P 500 index, which measures the performance of large-cap US stocks
- The Grayscale Bitcoin Trust (BTC) tracks the bitcoin market price – expressed per share of ownership in the ETF, which is calculated daily. It gives investors indirect access to cryptocurrency volatility
- The iShares Core MSCI Total International Stock ETF tracks the results of large-, mid- and small-cap non-US equities
- The Vanguard FTSE 100 UCTIS ETF tracks the performance of the FTSE 100 stock index, which is comprised of the UK’s top 100 companies by market capitalisation
- The Global X Cannabis ETF tracks the cannabis index, which provides exposure to companies that are active in the cannabis industry
- The WisdomTree WTI Crude Oil ETF enables investors to gain indirect exposure to the crude oil price by tracking the Bloomberg crude oil subindex
- The iShares US Energy ETF tracks the results of the Dow Jones US oil and gas index, which measures the performance of companies in the US oil and gas sector
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Types of ETF
There are a range of ETFs available for traders and investors, depending on their goals, market preferences and risk appetite. We’ve gone through the main categories of ETFs below.
Stock index ETFs
Stock index ETFs are funds that track the performance of a given index. As stock indices are nothing more than a number representing a group of shares, traders and investors have to find ways to trade on their price. ETFs can enable you to gain such exposure from a single position, as they can track multiple stocks.
For example, a FTSE 100 ETF would track the performance of the FTSE 100, and would either hold physical shares of the index’s constituents, or products that mimic its price movements.
Currency ETFs enable investors and traders to gain exposure to the forex market, without having to buy or sell the underlying currencies. In some cases, these ETFs will only track a single currency, but for the most part they track baskets of currencies.
Currency ETFs can be used to gain exposure to the economic health of regions – such as the EU – or emerging market economies. They can also be used as hedge against inflation and foreign asset risk.
Sector and industry ETFs
A sector or industry ETF will track an index made up of companies operating within the same industry. Most industries will have an index that comprises of major stocks. For example, the gold sector has the S&P 500 Global Gold Index, which is comprised of securities from the sector including miners, researchers and producers.
Like currency ETFs, sector ETFs can be used to take advantage of changes in an economy’s health and as a hedge against any existing positions. If an investor or trader has significant risk in a particular sector, they can mitigate this risk by shorting a sector ETF.
Commodity ETFs are not comprised of the underlying commodity, but rather derivative contracts that take their price from the commodity. This enables investors and traders to speculate on the price of commodities without worrying about the physical delivery or storage of the assets.
It’s important to note that there is a difference between commodity ETFs and commodity-linked ETFs, such as the sector ETFs described above. Commodity ETFs emulate the price of the underlying commodity, whereas commodity-linked assets track companies within the industry.
Inverse or short ETFs
Inverse ETFs are funds that move in the opposite direction to the underlying asset. So any movement that the asset makes, the inverse ETF does the opposite. They can be found on any of the above categories of ETF.
Investors and traders tend to use inverse ETFs as a means of opening short positions on the market. They can be useful hedges for existing long positions, or just a way of speculating on falling markets.
Leveraged ETFs are designed to mirror an underlying asset but use financial derivatives to amplify investors’ exposure. For example, a leveraged 2x ETF would maintain a $2 exposure to the underlying asset for every $1 of investor capital.
When using a leveraged instrument, losses can also be magnified. This is why it’s important to thoroughly research these ETFs and create a risk management strategy before a position is opened on them.
How to take a position on ETFs
Buying an ETF
ETFs are popular among investors as they can offer a broad market exposure from just a single position. You can buy and sell ETFs on sectors, indices, bonds, commodities and more by opening a share dealing account with IG.
When you start to invest, you’ll need to decide what proportion of your capital you want to invest in each different asset class or region, and then choose whether you want to take a passive approach or use an actively managed fund. Research has shown that it is difficult to find a fund manager who consistently beats the market after fees,1 which is why ETFs have become a common way of accessing a higher rate of return.
ETFs are low cost and share the best qualities of both closed and open-ended funds.
Trading an ETF
Trading ETFs is a great way to capitalise on shorter-term price movements within certain sectors. When you trade ETFs with CFDs or spread bets, you can take advantage of leverage to get amplified exposure to the ETF of your choice.
As a result, both CFDs and spread bets enable you to open a position for just a fraction of the cost of traditional investing. While leverage can magnify your profits, it can also magnify your losses, so it is important to create a risk management strategy before you trade.
Are ETFs a good investment?
ETFs are a good investment tool that can be used to build your portfolio. As well as generally being cheaper than actively managed funds, they share similar features to closed-end funds (those sold to investors by investment companies) as they can be traded throughout the day.
They also share similarities with open-ended funds (open-ended investment companies and unit trusts) as they are scalable – this means the price of an ETF is kept in line with its net asset value (NAV).
How does an ETF work?
ETFs work in much the same way as stocks. A fund manager will design an ETF to track the performance of an asset or group of assets, and then sell shares in that fund to investors. These investors then own a portion of an ETF, but do not have any rights to the underlying assets in the fund. Instead, ETFs track the value of the underlying, and provide investors with near-identical returns.
What is the difference between ETFs and shares?
A share is a portion of a company that can be bought or sold after it has listed on a stock exchange via an initial public offering (IPO). When you own a stock, you own a portion of that company – this means you could receive dividends if they are paid and will gain voting rights.
ETFs are traded in a similar way to stocks, but they track an underlying asset or basket of assets. They can track a range of markets, including company stocks, indices and commodities, but would not entitle the holder to own those underlying assets.
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How is an ETF’s price determined?
An ETF’s price is determined by the value of the fund’s underlying assets, known as the net asset value (NAV). This is most commonly expressed as the value per share, and is calculated daily based on the recent closing price of the underlying asset or assets.
However, an ETF’s market price can differ from its NAV as the price investors are willing to buy or sell at can vary depending on supply and demand.
How do ETFs make money?
ETFs generally make money when the value of the underlying asset they track rises. The exception to this is inverse ETFs.
The income you make can vary depending on the type of asset your ETF tracks. For example, if you own a stock ETF that tracks high-dividend stocks, you could make money from both capital gains and dividends paid out by those same stocks.
Your method of dealing ETFs will also have an impact on your returns, as investing or trading via derivatives will have different outcomes. Learn more about the ways to trade with IG.
1S&P Global, 2017