Exchange-traded funds (ETFs) are one of the most effective ways for entry-level investors to get involved with the financial markets. ETFs have been known to yield significant returns with very little need for micro-managing positions on behalf of investors. This is one of the biggest benefits of investing in ETFs for beginners to financial investments.
Within this guide, we’ll explore all you need to know about ETFs, including the concept, how they differ from mutual funds, the two types of ETFs to look out for, how ETF investments are taxed and much more.
If you are unfamiliar with what an ETF is, we’ll explain it to you in layman’s terms. An ETF is a collection of publicly listed stocks or bonds, packaged into one overarching fund. As an investor, you can acquire shares in this ETF, with the funds invested based on the nature of the overarching fund.
For example, it’s possible to invest in an ETF that tracks the FTSE 100 – the index of the top 100 UK-based equities by market capitalisation. Investors in an FTSE 100 ETF can make gains from the price movement of constituents within the FTSE 100, as well as the dividends paid out by individual equities. It’s a similar case with investing in US-based ETFs, with ETFs available to invest in the equities listed within the S&P 500 index.
How does an ETF differ from a mutual fund?
Many beginner investors struggle to see the difference between ETFs and mutual funds. That’s because the principle of both is almost identical. However, the way you invest in them is the key differentiator. With mutual funds, they are available at a set price each day, based on its net asset value. You can choose to invest a set amount via your chosen broker or directly via the company issuing the shares. The transactions are not instant.
Meanwhile, ETFs are tradable in the same way as equities on a leading stock exchange. Rather than investing a set amount into a mutual fund, you select how many shares you wish to buy or sell. The price of an ETF can move up and down in real time throughout a trading session.
Active ETFs Vs Passive ETFs
There are two primary ETFs you can invest in – active ETFs and passive ETFs.
● Active ETFs
Active ETFs deploy portfolio managers to beat the performance of the underlying index.
● Passive ETFs
Meanwhile, passive ETFs merely track the underlying index, be it the FTSE 100, S&P 500 or whichever selection of equities you plan to invest in.
How to invest in your first ETF
The most popular way to invest in ETFs is to open an account with an online brokerage. A share dealing account is one of the most efficient ways to invest in ETFs, as well as a host of equities and investment trusts. Bear in mind that profits in a share dealing account are taxable in accordance with your country’s capital gains tax legislation. However, the key benefit to share dealing is the lack of a capital limit. This means you can invest as much as you like per annum, unlike a stocks and shares ISA which carries a £20,000 annual cap.
The pros and cons of trading ETFs
To summarise the concept of trading ETFs as part of your financial investment strategy, be sure to make a note of the main pros and cons as a takeaway:
- ETFs do not require micro-management by retail investors. For example, passive ETFs are designed to match the underlying fund’s market
- It’s easy to buy and sell ETFs at the touch of a button with online
- Gain rapid exposure to a range of assets and equities for a cost-effective entry point.
- The diversification of most ETFs means the return potential is not as great as it would be when investing in individual top-performing stocks.
- ETFs can incur management fees, unlike if you were to buy a portfolio of individual