What is an exchange traded fund? – MoneyWeek Investment Tutorials



one of money week's favorite investments is the exchange-traded fund or ETF so in this video I'll do a beginner's guide to what exchange-traded funds are why we like them and in fairness why they're not perfect in every situation they do have one or two drawbacks and it really be fair of me to point out what they are okay so what is an exchange-traded fund or an ETF in short it's a security normally a share that simply tracks an index a basket of stocks or something like a commodity say gold so what's the point of that well the point of that is this if you want exposure to say the S&P 500 index or the footsie 100 what better way they get it potentially than to simply buy one share through your broker or let's do it along London Stock Exchange so it's nice and easy to get hold of it's got similar charges attached to buying a normal share in a standard company and that gives you exposure to an entire index or something that might be quite difficult for you to buy and sell in the commodities market that's the point of exchange-traded funds in a nutshell these listed shares typically that give you exposure directly to something else and that something else is typically an index a basket of say shares or a commodity alright so how do they work well basically I could telephone my broker and say I want to buy an exchange-traded fund okay and I need to pick one they all have names now the earliest ones had kind of snazzy names so a spider was a fund that tracked the S&P 500 a diamond was a fun that tracked the Dow Jones 30 right that's financial markets Wizards being a little bit exciting about the way they name products but these days there are loads of EDS that track all kinds of indices so I need to be sure about what I'm asking for so if I want something that tracks the S&P 500 I might indeed ask for the spider which is named after the phreatic code that's used to denominated separated mother shares all right now my choice is do I want the Sterling listed exchange-traded funds on to buy a sterling share or I could buy us one if I may you in u.s. investor in other words exchange-traded funds are available on all major exchanges in the relevant currencies so the UK investor I might decide to pick up a share the tracks one of the major indices okay and then what do I do what happens next well the idea is that if the underlying index moves up by one percent then the share moves up by one percent here's the beauty I could be buying a very small amount of the share I mean the index could be something big okay that represents loads and loads of companies but I can just buy you know one share safer you know if I'm a u.s. investor one dollar alright and if the index goes up one percent that share price rises one percent the index falls one percent the share price falls one percent or if in theory the gold price goes up one percent the share goes up one percent down one down one that's the theory all right and what's the point of that remember it's that I don't have to get involved in then lying asset I can just buy this share and use that as a proxy for the asset itself and buying shares you straight forward okay everyone knows how to buy shares once they've got a bit of experience okay so I'm going to expect to incur similar sorts of costs to buying Sayre a man United chair all right so I'm going to potentially pay out the bid-offer spread all right a little bit of commission to my broker do see my video on how to buy shares if you're not sure about that but one benefit of exchange-traded funds is you don't pay stamp duty so you don't pay that half a percent upfront you pay on most other shares all right and now I have it so I've got a share in my portfolio that simply mirrors the performance of the index as I've chosen all right so advantages it's a simple product up one percent down one percent or a mirrored in the performance the share and it's relatively cheap all right charges on exchange traded funds unlike say an alternative the unit trust which is something your broker might push at you because the commissions tend to be a bit higher charges for exchange-traded funds annual management fees typically quite low most have an annual management fee or a total expense ratio of less than 1% lots actually do much better than that and have an expense ratio less than half a percent all right so that's pretty damn competitive I mean half a percent that could be you know a third of the price for investing in something like unit trust for example okay so you've got something that simple there's cheap you can buy in any denomination I mean the minimums one share so you about one share or ten shares or hundred shares your flexibility there and it's liquid unlike say buying a unit trust which is another type of fun that could track things okay you can buy inside exchange-traded funds any time of day while the markets open all right you don't have to wait for a valuation point as they call your unit trusts which might only be twice a day or something you can just trade them like a normal toy share any time of day all right so lots and lots of advantages now it would be misleading of me to say that it's all one-way traffic and I what you should do is ditch everything else in your portfolio and buy exchange-traded funds okay however exchange-traded funds are brilliant particularly in well-known developed markets all right because basically all you're lending Epton exchange-traded fund is tracking or following the underlying index or commodity right so immediately critics would say we are not going to beat the market one of these things are you all right the market on their fridge goes at 1% the Cheryl got 1% about 10 percent okay so you want to beat the market these things are not so good are they and that's true but they do offer a very cheap easy way of tracking a market okay so the reason they're cheap is you're taking away the fund manager these are so called passive instruments and all that means in technical terms is there's typically a computer program okay monitoring the underlying holding okay whether that be shares in an index or a commodity like gold there's not our fund manager sitting there taking investment decisions as your cash flows in and out of the exchange very fun all right so that's what keeps the costs low now on the flip side all right these are passive they track alright so you will meet the performance of an index you won't beat it again theory you want to beat the market our managers would say you need to pay them to do exactly that but since so few of them actually do ever beat the market we'd say given a choice we'd take the low-cost track exchange-traded fund instead okay so problems alright if you want to beat the market ETS won't do it um and do they perfectly track the underlying asset easy in a bit of a simplification say that if the underlying index goes at 1% the ETF goes up 1% yes it is all right that's for a couple of reasons potentially one is tracking error just be a little bit careful okay the fund manager the exchange rated fund manager that is issues the ETF okay so you can buy the share on one side if you like and then in theory is buying shares that exactly replicate and index such as S&P 500 right but the exchange-traded fund may not hold all of the shares and index you may just hold most of them and that means that the performance of the ETF won't exactly replicate the performance the underlying index in Y vary a little that's called tracking error and that's a fact of life some ETFs the solution is to look under the bonnet get the funds sheet and find out what's in there okay you can do that there's one problem the next one is some of the more sophisticated ETFs in the commodities market for example don't actually physically hold the underlying asset okay the fund may not physically own gold for example it may create an artificial position like holding gold using derivatives and if that's the case there's another source potentially of what I'd call tracking error you won't necessarily see the sort of 1% up lifting the gold price mirrored by the 1% uplift in the ETF another issue is currency okay be careful if the underlying asset is denominated in a currency which is not the one you're buying the ETF in on your local exchange you'll get a foreign currency movement okay between the ETF and the share your body alright obvious if you line up the currency than lying asset and the currency the ETF that shouldn't be so much of a problem okay so all those things can be sources or what are called tracking error now next point is it true to say that all ETFs are cheap mostly they are and it's the simple ones you want okay so if you're just tracking large cap US stock why pay our fund manager there's plenty of research that suggests they just don't do very well all right because all the information about those companies is well-known all investors can get hold of it so how do they beat the market they tend not to so there there's a great case for picking up a nice simple what I call plain vanilla exchange-traded fund because you probably get better performance all right all set you know worse for less money in terms of cost okay but those plain vanilla reach Jets are being joined in the market by sexier ones that are more expensive and try and rule your money in now in this video I'm not going to go through all the different types PDF but suffice if say the following words spell danger to me in the etf market or spell cost and spell complication and we don't like cost and we don't like complication of money week inverse ETFs okay as the market Rises they go down and vice versa sounds a bit fruity can be and can also be expensive all right not the novices that one geared ETFs all right those are the ones where the market goes up 1% ETF in theory goes up 2% or 3% all right and vice versa you can have an inverse geared right now it's sounding pretty hairy and be careful because the performance of those things can be pretty damn difficult predict and you'll probably be paying extra money for the privilege of having this slightly sexier sounding ETF finally the sort of strategy ETFs you know the the active fund management industry trying to fight back and say well we want to make money out of ETFs they're too cheap that must be a way they're offering in exchange traded fund that mirrors the strategy of a great investing guru mmm jury's out on whether that's a good idea or not fundamentally the point of an ETF is to give you cheap easy straightforward access to a basic index or a basic asset okay so steer clear of complication and steer clear of cost in this market right so in summary exchange-traded funds an easy way for an investor to get access to something like an index or a commodity or a basket of shares for example that having to go to Houston expense of buying positions and every single component all right they're listed on major exchanges they could be bought through a broker like a normal share traded pretty much any time of day and you'll incur similar costs to trading a plane share other than that stamp duty tax that I mentioned in the UK alright so when would use them in summary basically we would use them where there's no clear case for involving active fund management and that tends to be in the well-known developed markets where frankly some manager is pretty difficult to get edge

20 thoughts on “What is an exchange traded fund? – MoneyWeek Investment Tutorials

  1. I have a question I wonder if anyone can answer. Is there a reason why I should invest in an ETF instead of something like an index fund? Since based off my current understanding they are quite similar

  2. Pretty much betting on international money supply. And buying a currency that you believe has a low rate of money supply production. Either through govt money printing or through loan creation from fluctuating interest rates set by that nation's central bank

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  4. Can someone invent a financial vehicle where we can make money or trade on the amount of astroturfing spam posts on youtube?

    An ETF for that would make millions.

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