ETFs Explained: A Smarter Way to Diversify.

How Do ETFs Work?

An ETF pools investors' money and uses that capital according to the fund's investment objective. For example, an ETF may aim to track a particular stock market index by holding some or all of the securities represented in that index.

When you buy an ETF through an investment platform, you are buying units or shares in the fund rather than purchasing every underlying investment separately. The value of your ETF investment changes as the market value of the underlying holdings changes, subject to the ETF's structure, costs and tracking performance.

ETFs and Index Tracking

One of the most common ETF structures is an index-tracking fund. These ETFs aim to replicate the performance of a particular benchmark rather than having a fund manager select individual investments with the objective of outperforming the market.

For example, an ETF could track a broad equity index. Instead of buying every constituent yourself, the ETF gives you exposure to the basket through one investment.

However, an ETF may not perfectly match its benchmark. Costs, taxes, trading conditions, portfolio adjustments and the fund's method of replication can create differences between the ETF's return and the index it tracks.

How ETF Prices Change

ETF prices change throughout the trading day as investors buy and sell ETF units on an exchange. The underlying assets also have changing market values.

Supply and demand in the market can influence the ETF's trading price. Market makers and the creation and redemption mechanism used by ETFs are important parts of how the trading price can remain relatively close to the value of the underlying portfolio.

Accumulating vs Distributing ETFs

Some ETFs are structured to distribute income generated by their underlying holdings to investors. These are commonly described as distributing or income-paying ETFs.

Other ETFs reinvest income back into the fund. These are often described as accumulating ETFs. The appropriate structure depends on an investor's objectives and circumstances.

Why Investors Use ETFs

Investors may use ETFs to gain diversified exposure to a market, sector, asset class, investment theme or geographic region without purchasing every underlying asset separately.

For a long-term investor, a broad-market ETF can be one way to build diversification. Other investors may use more specialised ETFs to obtain exposure to a particular sector, country, investment factor or asset class.

Are ETFs Low Risk?

An ETF is not automatically low risk simply because it holds multiple investments. The level of risk depends on what the ETF owns and how concentrated or volatile those underlying investments are.

A broad equity ETF may hold hundreds or thousands of companies, while a narrow sector ETF may concentrate its holdings in one industry. A bond ETF can also have different levels of interest-rate, credit and duration risk.

Investors should therefore look beyond the ETF label and examine its underlying holdings, objective, geographic exposure, sector allocation and risk characteristics.

ETF Costs to Understand

Costs can have an important effect on long-term investment returns. The ongoing charge or ongoing costs figure can indicate some of the expenses associated with running a fund, although investors should also consider other costs.

• Fund operating costs
• Platform or account fees
• Trading commissions where applicable
• Bid-ask spreads
• Currency conversion costs
• Taxes or charges that may apply depending on the investment

A low-cost ETF is not automatically the right ETF. Investors should consider the fund's objective, diversification, tracking performance, liquidity, structure and overall suitability alongside its costs.