If, like me, the beginning of your journey of understanding the markets is an unlimited list of questions – 5 for every one concept that you learn; then Meedo's here to help…
This content is for educational purposes only and is not financial advice. Investment values can fall as well as rise, and you may get back less than you invest.
What the hell is an ETF? It may help you to think of it as a company, whose job is to own a whole bunch of companies, for the purpose of allowing you (an investor), to be able to really easily buy, and invest in, a whole bunch of companies in one go.
Here's why they exist as a type of product – as an investor, I may decide that I want to invest in not just one single company; because if I do, and that single company's stock price decreases significantly, my investment decreases in value significantly. Because of this reality, many investors decide to invest in a whole range of different companies, to spread / reduce this risk – a broad index is generally less likely to experience the kind of sharp, single-cause drop that an individual company's share price can. That said, diversified funds can still fall significantly in value, including during periods when entire markets decline together.
If you decided to invest in the S&P 500 (the 500 biggest companies within the US), you have 2 options – buy 500 different stocks, or, buy a single stock of an S&P 500 ETF; you're only able to do this because some official group of people have decided to buy an equal amount of each of those 500 companies, package it up into an ETF, and then allow you to buy one stock / share of it.
If you're interested in investing in ETFs, because they allow you to lower your investing risk, or because they could allow you to invest in an entire theme / sector (ie. a biotechnology ETF, or an agriculture tech. ETF etc.); there are a few things that you should be aware of:
There are often many, many, very similar ETFs, for any single type / theme (ie. S&P 500 ETF)
There are many reasons for this, and one significant one is because there are many different companies that make & provide ETFs; they're often named by the company that has made by the ETF, followed by the theme ie. HSBC S&P 500 ETF. The name of the ETF should generally give you an indication of what it's associated with, but ensure that you look at what's called the key investor document (KID) to understand exactly what the ETF is made of, and how it works. You'll find the KID on a page in your investing platform, at a point before you trade the product.
ETFs come with small costs, that automatically get taken from the value of your investment (ie. you don't directly have to make extra payments)
If you see the acronym TER / OCF, they refer to this cost. Conceptually, you pay a very small relative fee, for the luxury of not having to buy those 500 shares / stocks – the cost isn't charged to you as a separate transaction, and it doesn't reduce the number of units/shares you hold. Instead, it's deducted from the fund's assets before the fund's value is calculated. The effect is: your unit count stays the same, but the price of each unit grows slightly more slowly than the underlying index would suggest on its own, because the fund's assets are being slightly eroded by the fee on an ongoing basis.
The thing that you really need to be aware of, is the fact that, what looks like completely negligible charges (the TER / OCF) of 0.1% or 0.35% can actually make a meaningful difference to the costs you pay over time – here's a worked example:
The following example uses a hypothetical 7% annual growth rate for illustration only. It is not a forecast or guarantee of returns. Investment values can fall as well as rise, and you may get back less than you invest. The figures below are intended purely to demonstrate the relative impact of fees, assuming identical growth in both funds.
Imagine two near-identical ETFs, both tracking the same index. Same holdings, same exposure, same hypothetical growth — the only difference is one has an OCF of 0.15%, the other 0.35%.
You invest £10,000 in each, and both grow at a hypothetical 7% a year for 10 years.
Fund A (0.15% OCF): grows to roughly £19,200
Fund B (0.35% OCF): grows to roughly £18,820
Assuming identical growth in both funds, the only variable is the fee — and that fee difference alone costs you roughly £380 over 10 years on a £10,000 investment, purely from a 0.20 percentage-point difference in fees.
Not huge. But scale it up, or extend the timeline, and the gap compounds. On £50,000, that same 0.20% difference in fees becomes roughly £1,900 lost to charges alone — for two funds doing functionally the same job.
There is a reason behind the difference in fees that ETFs charge, mainly due to whether the fund is actively / passively managed, and a few other details of how the ETF is structured – make sure that you do some research before deciding on the exact ETF that you decide to invest in, in order to understand why it's likely to have the ongoing cost that it does.
Some pay dividends, others re-invest them automatically into the fund
A dividend is a payment from a company, as a small 'thank you' for investing in their company – not all companies' shares give you it. There's a much higher likelihood of an ETF offering dividends, purely due to the fact that it's likely composed of many companies' stocks / shares. Ensure that you know whether the ETF you're investing in 'distributes' dividends ie. you receive a physical payout into your investing account, at certain times within the year; or whether the ETF 'accumulates' this payments, and holds onto them, in order to re-invest that money back into the fund, to buy more of the company stocks / shares that make up the ETF – in this case, you'll likely see a small difference in the value of the ETF ie. at a single point in time, the value of an accumulating ETF of the same theme, is likely to be fractionally greater than the equivalent, distributing ETF.
There are evolutions of ETFs, that are more generally called ETPs – exchange-traded 'products'
Things get quite complicated, quite quickly here – there are conceptual variants of ETFs that do some interesting things – like change in value by a factor of 2, or 5, compared to the company or index that they are associated with; or even that do the complete opposite. If Tesla increases by $1, an inverse ETF should decrease by $1. These are generally considered high-risk and complex products, and may not be suitable for many retail investors. All you need to know is that if you're finding yourself interested in these kinds of products, there may be a more useful type of account to use, to achieve what you're after – potentially a CFD, or spreadbet account.
But the most important thing to know is, that for some complicated underlying reasons, in some conditions, the ETP may not actually do the thing that it's supposed to, during a specific period of time. If you're interested in these products, do your research & ensure that you understand how they work, before investing in them.