Exchange traded funds: A guide to how ETFs work and how to invest

Exchange Traded Funds aim to mimic the performance of a particular market or index such as the FTSE 100 and like a traditional tracker their value is determined by whether or not the index rises or falls.

But ETFs differ in that they are traded like individual stocks, on an exchange such as the London Stock Exchange and can be bought and sold through brokers in the same way as any other listed stock.

You can also reach foreign markets that are sometimes out of reach of the ordinary investor. We reveal how ETFs work and where to invest.

ETFs: Exchange Traded Funds can give you exposure to more markets

ETFs: Exchange Traded Funds can give you exposure to more markets

ETFS are passive investments in that they are not actively managed by a fund manager who chooses which assets to buy and sell. An ETF has holdings in every company on the index and only buys and sells holdings to reflect movements in the market.

One of the main attractions of ETFs over traditional trackers or active funds is that they are priced continuously throughout the day, whereas conventional funds are priced just once a day and you do not know what the price will be before you buy or sell.

ETFs are therefore ideal for investors who want to profit from short-term movements. You can buy ETFs that track exotic markets such as Brazil, Eastern Europe, Taiwan, and even Korea – areas that historically have been difficult for small investors to gain access to.

Market Overview

ETFs originated in the early Nineties in the US - the first was launched in 1993 - and was based on the American S&P500 index.

After the launch of the first Exchange Traded Fund on the New York Stock Exchange, and the subsequent successful development of the US ETF market, the European ETF market is today one of the fastest-growing segments of the European asset management industry.

There are now more than 221 asset management companies offering more than 5,000 ETFs on 59 stock exchanges.

Download a FREE broker guide to ETFs

Exchange Traded Commodities


ETCs are simple and transparent open-ended securities that trade on regulated exchanges. ETCs enable investors to gain exposure to commodities such as gold or oil.

ETCs are very similar to ETFs because they are both open-ended, continuously traded and have multiple market makers. With ETCs, investors can gain access to a wide variety of commodities from oil to coffee, gold to corn and cotton to soybeans.


Most ETFs levy lower annual charges than even the cheapest traditional tracker funds but as with stocks, you have to pay a dealing fee to buy and sell ETF shares, which can be a problem for investors who trade frequently or invest regular sums of money.

 In regards to the annual charge to investors, ETFs are significantly cheaper than the vast majority of Oeics and unit trusts.

Costs vary, but they can be as low as 0.1 per cent but remember there will be stockbroker costs. In addition there are no stamp duty costs with ETFs.

Most investing platforms will provide access to ETFs but you will also have to consider annual administration charges and dealing fees as this will push up the total cost of investing. Some also charge extra to hold shares and exchange traded funds on top of the annual fee.

There is a trade-off between admin charges and dealing fees to be weighed up, along with whether your situation means you will be best with a flat or percentage fee. A flat fee tends to work out better when investing a large amount, while a percentage fee can be better for small investments.

You also have to decide on the other type of products you want to invest in. Some platforms will be better for fund dealing, some will be better for shares and investment trusts, and some have a wider choice of products with annual management charges that have been negotiated down for customers.

What are the downsides?

As ETFs and ETCs are passive investments mirroring a market or index, your investment's success will depend entirely on the fortunes of the market and/or index in which you are invested – if they go down, your cash will follow them.

Even though there is no stamp duty and costs are significantly lower than those associated with traditional unit trusts and Oeics, the price advantage may not always be as big as it initially appears – as trading costs could quickly add up if you are investing regular sums of money. In such cases you may well be better going with a traditional fund but for lump sum investors they offer good value for money.

There has also been concern from regulators about the emergence of 'synthetic' ETFs that use derivatives and swaps to track an index rather than products that physically replicate it. The Bank of England has previously expressed concern that investors may not understand what they are investing in with a synthetic structure.

Who supplies ETFs and ETCs?

The major providers of ETFs are State Street, Lyxor Asset Management, iShares, Vanguard and ETF Securities.


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