What is an Exchange-Traded Fund?
The newest form of investment funds are called exchange-traded funds (or ETFs). They were only launched in 20220, but they’ve been growing in popularity among DIY investors ever since. Here’s how they work and why you might want to add them to your portfolio.
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What is an ETF?
An ETF is a basket of investments that usually includes shares or bonds. They tend to track the performance of an index like the FTSE 100 index of the biggest companies listed on the London Stock Exchange, or the S&P 500 index representing the largest 500 companies in the US.
Like investment trusts (but not open-ended funds), ETFs trade on a stock exchange, and you can buy or sell them at any time during trading hours at the price shown. This means their prices fluctuate throughout the day, going up and down depending on investor demand.
Who are ETFs for?
In general, ETFs suit investors who want to save time and not manage a portfolio of individual stocks. You can use ETFs to access to a range of companies and countries. But they are particularly good for providing exposure to a particular investment theme, such as energy or technology. They’re often also used as low-cost building blocks for managed funds.
Why choose ETFs?
The primary advantage of ETFs is that they are low cost. Some that track the FTSE 100 or S&P 500 charge as little as 0.1% of the value of your investment, which works out at £10 on a £10,000 investment.
Charges for funds and investment trusts vary, but as a rule of thumb, charges (called the ongoing charges figure, or OCF) for a UK or US fund or trust would be around 0.85% to 1%, which works out at £85 to £100 on a £10,000 investment.
The extra fees you pay to own an actively managed fund or trust versus an ETF will be worth paying if the fund outperforms, but there are no guarantees that this will happen.
Another advantage of ETFs is transparency. With open-ended fund or investment trust, you generally don’t see the changes to the underlying holdings every day. In fact, with an open-ended fund you only usually see the top ten holdings. But with an ETF you can usually see all the underlying investments every day.
When investing in stock markets ETFs either use ‘physical’ or ‘synthetic’ replication to create the same performance as the index. It’s an important difference.
Physical replication means buying a small share in each of the underlying investments in the index. Some ETFs actually hold all of the underlying investments that go to make up the index that they track. Other ETFs may hold a sample of the companies in the index.
Synthetic replication is a way of recreating the index return by using complex financial derivatives, such as futures and ‘swap agreements’. It can keep costs low but introduces an extra layer of risk to the product, not least the risk that you, as an investor, don’t fully understand what you’re holding. And you also need to trust that in the event of something going wrong, the ETF provider has put the right underlying deals in place.
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Why are ETFs so popular?
In recent years, more and more investors are using ETFs. For example, Hargreaves Lansdown’s customers have access to over 1,500 ETFs and the investment platform reports that an increasing number are using ETFs as part of their portfolio, rising from 5.7% to 11.1% over the last five years.
Interactive Investor, another investment platform, reports ETFs have experienced an uptick in demand, with 20 now in its Top 50 most popular funds index, up from 14 a year ago. The Top 50 Fund Index is based on the number of buy trades made by interactive investor customers over a three-month period (in this report 1 April 2025 to 30 June 2025). It is not based on volume.
ETFs that track long-established equity indices such as the MSCI World, S&P 500 and FTSE 100, are popular ways of gaining core exposure to major stock markets. Investors, however, have also been seeking out specialist ETFs that track the ups and downs of a particular theme, with technology ETFs and defence ETFs featuring in the top 50.
Types of ETF
Traditionally, most ETFs were passive, which means they aimed to track the performance of an underlying index. But now there’s a new type of actively managed ETF too. Here, specialists select investments for the funds, and change them regularly, with the aim to outperform the benchmark.
When it comes to tracking the performance of commodities, such as precious metals or energy, investors can buy a similar type of investment called exchange-traded commodities (ETCs). Gold ETCs tend to be popular, allowing investors to track the price of gold, without the need to arrange for expensive storage and insurance.
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Where to buy and hold your ETFs
You can buy ETFs on most investment platforms, and some of the robo-advisers use ETFs building blocks for their portfolios too.
ETFs can be held in a Stocks and Shares ISA, which allows you to invest in a tax-efficient way and protects your income and profits from UK income and capital gains tax.
When it comes to tax on investments held outside ISAs or other tax-efficient wrappers such as pensions, ETFs are treated the same way as most traditional investments. This means you may need to pay capital gains tax on any profit that you make when you come to sell them and income tax on any income received.
Some ETFs pay dividend income to their investors and can provide you with a steady (though not guaranteed) income stream. The income is generally paid quarterly, but some ETFs may offer monthly income.
You can usually choose for your dividends to be paid out as cash, or us them to acquire more shares in the same ETF. However, there may be a fee for reinvesting dividends.
Here at Be Clever With Your Cash, we’re not regulated to give you financial advice. We aim to give you the facts about a provider or investment but it’s up to you to decide if it’s suitable for you. If you’re looking for more personalised guidance, find a financial adviser who can give you specific advice. Remember that your capital is at risk when investing — don’t invest more than you are prepared to lose.