Investing in ETFs: What they are and how they work

Everything you need to know about investing in ETFs:

Find out all the useful and necessary information on why we invest in ETFs. The topics covered in this guide are as follows:

What ETFs are
The advantages of ETFs
How Exchange Traded Funds work
How to choose funds
The costs involved in ETFs
Strategies for investing in ETFs
Frequently asked questions

Invest in ETFs with Moneyfarm:

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What are ETFs?

ETFs (Exchange Traded Funds) are passively managed investment funds. As with all funds, buying an ETF is like buying a selection of stocks, bonds or other investments. Investing in a fund is equivalent to pooling your resources with other investors and having a fund manager buy instruments on your behalf with the money. ETF performance is, broadly speaking, measured by combining the individual value of the stocks that make it up.

What are the advantages of ETFs?

1. Liquidity

As listed instruments, ETFs are highly liquid. This means that it is easy and straightforward to buy or sell shares without running the risk of seeing their value drop.

4. Transparency

Transparency is baked into ETFs. It’s easy to get a full picture of the instruments that make up any given ETF and to evaluate them from multiple perspectives - from currency exposure to creditworthiness.

2. Versatility

Thanks to the way they’re put together, ETFs mean that even smaller investors can access key indices without having to buy the securities that make up the basket individually.

5. Security

The assets that make up ETFs are separated from that of the company that issues and manages them. So, even in the event of any bankruptcies, the funds are returned.

3. Efficiency

Passive management can make investing in ETFs efficient in its profitability. When you consider the fact that the management cost of ETFs rarely exceeds 0.5%, they start to look like cheap options.

6. Strategy

ETFs have made it easier and less time-consuming to put together multi-asset strategies that aim for medium and long-term growth by following trends in the market. They’re based on macroeconomic trends, broadly, an effective way to plan.

Discover how Moneyfarm uses ETFs

How do ETFs work?

The thing that sets ETFs apart is they lend themselves to passive strategies. They’re designed to replicate the performance of a given index or the price of a given asset class - put simply, they allow you to follow that performance on a smaller scale.

The FTSE Mib ETF will, for example, aim for the same daily result as the index it’s tracking. SImilarly, the gold price ETF will reflect changes of price in the gold market. To get this right, ETF managers buy shares of the securities of the reference indices - known as benchmarks - to build an asset with the same proportions. So, you end up with an investment that accurately reflects the value of the index it replicates.

ETFs are different to active funds. Rather than giving a manager discretion to buy securities and chase returns, investing in an ETF means you can clearly see what you’ll be investing in ahead of time. The performance, then, depends on the fate of the index rather than necessarily the skill of the manager.

How to invest in ETFs and which ETFs to choose

When choosing your ETFs, you should look at more than just the asset class they hold. There are, after all, multiple options for each single asset class. So, how do you choose between two different ETFs that reflect the same index?

Here are some key factors to consider:

The number of assets in the fund, which affects its liquidity.
The replication method, physical or synthetic, favouring the former where possible.
The cost.
The reference currency.
The provider, or fund management house, favouring companies with a strong track record.
Premium or discount: sometimes, when there is particular demand for a product, you can create a premium or discount when selling your shares.

Our task, as managers, is to consider the impact of all of these factors when making the right decisions on behalf of our customers.

Our ETF portfolios

Is investing in ETFs worthwhile?

ETFs are practical and typically inexpensive tools. In recent years, they’ve boomed in terms of popularity, particularly while the ability of more active managers to consistently outperform the benchmark has been questioned.

ETFs are publicly traded instruments and ETF shares can be bought and sold at any time, just as if they were ordinary equities or bonds.

Why invest in ETFs?

Unlike most active mutual funds, ETFs are bought and sold on the exchange. To give you an idea of the size of the market, around 7,600 ETFs are listed globally. What this means for investors is greater flexibility and all the guarantees that come with investing in a regulated market.

Investing in ETFs allows you to:

Diversify your investment

Diversification has become an absolute must for any investor that wants to mitigate the risk in their investments. Building a diversified portfolio was traditionally expensive and complex, because it involved buying a lot of stocks. Now, in a single instrument, ETFs represent simple and effective diversification.

Low costs

ETFs reduce investment management costs. Thanks to their structure, wealth managers are able to optimise buying and selling, lowering the overall management costs incurred. There are, however, some potential limitations to bear in mind when investing in ETFs. Some argue, for example, that while passive investments have an advantage in healthy markets, they pay a premium in the event of market downturn.

Our strategy for investing in ETFs

Diversification through ETFs

The portfolios we build for our clients are made up exclusively of ETFs. We firmly believe that ETFs are the best choice for investors who want to keep costs down without sacrificing diversification. By purchasing just a few instruments, ETFs allow us to create portfolios that invest safely and effectively across all the key asset classes and geographies. Our Asset Allocation team, in addition to selecting the ETFs initially, evaluates the strategy on a regular basis to ensure that we keep pace with developments in the markets. Our costs associated with our wealth management process is about half that of traditional managers.

How we choose the right ETFs

When you invest, the first thing you have to establish is your goals and your attitude to risk. At Moneyfarm, we ask a series of questions to determine these factors for each individual investor, which is then evaluated by our consultants. The process helps us make investment decisions around our investors’ goals. We recommend completing the profiling questionnaire even if you’re just curious - it takes around 20 minutes and is free from obligation. We also offer free, independent advice on your existing investments.

Discover our strategy

FAQs on Exchange Traded Funds

We use a rigorous process when selecting ETFs for inclusion in our clients’ portfolios. The factors we take into consideration are costs, liquidity, the provider and the method of replication – we don’t rule out using smart betas (a choice we have made in the past). One of the problematic aspects of smart betas is that the qualitative-quantitative strategy has a higher cost than normal ETFs and therefore makes it more difficult to justify its use as part of our overall strategy. It should also be emphasised that not all smart betas are considered suitable for private customers (such as those with non-public benchmarks).

Not all ETFs, in order to replicate their reference index, buy all the securities present in an index (so-called physical replication). Some instruments select a sample of stocks that is in this case representative of the index (synthetic replica). In this case, the value of the ETFs can also diverge from the benchmark.

Certainly. ETFs are an excellent tool for investing in commodities thanks to their practicality and efficiency. There are gold ETFs, oil ETFs, water ETFs and a host of other ETFs that invest in different commodities.

Investments held within an Individual Savings Account (ISA), such as ETFs, can offer tax benefits, as any gains made are typically exempt from Capital Gains Tax (CGT) and Income Tax.

However, it’s important to note that this tax advantage applies specifically to ISAs. If you are investing through other accounts, such as a pension, different tax rules may apply. When you eventually draw down from your pension, a portion of it may be subject to taxation.

Tax treatment depends on your individual circumstances and may change in the future.

Much like when you invest with Moneyfarm, the assets an Exchange Traded Fund invests in are ring-fenced and held by a separate custodian. In the unlikeley event that an ETF provider goes into administration, you’ll still have access to the ETF assets you own. ETFs aren’t protected under the Financial Services Compensation Scheme. You cannot claim compensation simply because the value of your investment falls. All investments involve some risk. An index tracker will lose money if the index it is tracking goes down.

The ETF selection process goes hand in hand with the portfolio construction process. Once the weighting of the asset classes in the portfolios have been selected, one or more indices representing that asset class in the portfolio are chosen.

Once the index has been established, the next step is to choose the best ETF on the market that follows that given index. Each ETF is different and, even if it represents the same market index, there can be differences in construction and in performance. The main criteria we consider when evaluating the quality of an ETF are the following, in order of importance:

Tracking error: The difference between its performance (net of fees) and the performance of the reference index.
ETF construction: We tend to favor physically relicated ETFs. Occasionally, when factors like liquidity, cost and tracking errors are taken into account, we will choose a synthetic ETF.
Collateral: Particularly with synthetic ETFs, it’s important to evaluate the securities placed as collateral in the instrument.
Liquidity: We try to include instruments that are as liquid as possible. This is a determining factor in the riskiness of the instrument.
Cost: Cost remains a relevant component in the evaluation of ETFs.
Reliability of the manufacturer: it is important to consider the manufacturer’s reliability and their interest in continuing the ETF business and sponsoring the products they build.

All of these factors are evaluated and monitored over time, with the analyses submitted to the company’s Investment Committee and approved by the Board of Directors.

We invest in ETFs for three reasons: they provide exposure to a broad range of asset classes; have lower costs than actively managed funds; and offer more predictable performance than an actively managed fund.
Managing risk is at the core of our philosophy. ETFs allow us to create an optimally diversified portfolio to manage the risk in our portfolios and our portfolios hold a group of different funds, diversified across geographies and asset classes. A diversified portfolio is better insulated against downside risk and evidence suggests that it’s difficult for active stock pickers to consistently outperform the market over time.

An Exchange Traded Fund (ETF) is a fund that tracks a market index (like the FTSE 100 or S&P 500), a specific commodity, bond, or even a basket of assets. In essence, ETFs own shares and trade them to reflect moves in the index they are tracking. They can be traded exactly like individual stocks, but because they are based on an underlying index or investment, they offer more diversity than individual shares. ETFs charge lower costs than traditional investment funds as they don’t involve active management.

ETFs are a popular low-cost alternative to mutual funds, although they do have a small cost attached to them. On average, you’ll be charged 0.2% per annum for this underlying fund cost at Moneyfarm. This cost is charged by the fund managers and is built into the price of the ETF on any given day. You will not, therefore, see fund charges being deducted from your portfolio directly. This fee can be as much as 1% with mutual funds, sometimes more. Please note, there will always be a fund fee with ETFs, regardless of who you invest with. You’ll also be charged a management fee by Moneyfarm, which is separate to the fund fee. If you invest £20,000 with Moneyfarm, you’ll be charged 0.7% in management fees. In this instance, you’ll pay a total annual management fee of £140 to Moneyfarm directly. The market spread effect also impacts your investments. This is a characteristic of trading on the financial markets and represents the difference between bid and ask (buying and selling) prices for an investment at a specific time. This can be up to 0.09% at Moneyfarm, but you’ll always see the real price you buy and sell assets at.