What are ETFs and how do they work?

ETFs are pooled investment vehicles that offer investors the chance to achieve diversified exposure to a broad range of assets, such as stocks or bonds. Unlike traditional mutual funds, however, ETFs are traded on major stock exchanges, which means ETF shares are available to be bought and sold whenever the market is open.

Crucially, ETFs can maintain this high level of liquidity while also ensuring that investors receive a fair price at all times, irrespective of demand in the market for an ETF’s shares. This ability to trade ETFs throughout the day at a price that is close to the total value of their underlying assets (known as the net asset value or NAV) is made possible by a unique pricing mechanism that allows liquidity providers in the primary market (called authorised participants and market makers) to create new ETF shares when demand is high, or redeem shares when demand drops. As well as supporting liquidity, the ETF pricing mechanism can help to lower the overall cost of investing in ETFs and promote more efficient portfolio management, with in-kind redemptions and secondary market trading both helping to reduce the need for an ETF to buy and sell underlying holdings in order to meet changes in investor demand.

The efficient pricing of ETFs also requires a level of portfolio transparency that’s uncommon in traditional mutual funds, with most ETFs disclosing their holdings to the market on a daily basis. Being able to see an ETF’s current market and risk exposures is another key benefit of investing in ETFs, helping investors to make more informed decisions based on the most up-to-date portfolio information. Daily portfolio disclosures can also help to improve pricing in volatile or illiquid markets. Altogether, the ability to trade ETF shares efficiently and transparently throughout the day at a fair price, and with competitive fees, makes ETFs an attractive option for any investor looking to build a diversified, liquid and cost-effective portfolio.

Different Types of ETFs cater for different financial needs

The benefits of the ETF wrapper can be applied to a wide range of strategies. This is because ETF portfolios themselves are managed with reference to the performance of a specific group of assets in an index, also known as a benchmark. These benchmarks can be well-known stock indices, such as the S&P 500 or the FTSE 100, but they can also be focused on specific sectors or industries (for example, technology or healthcare), or higher risk assets, such as emerging market equities and high-yield bonds – the list is practically endless.

Many ETFs are passively managed. This means their portfolios simply aim to replicate the holdings and risk characteristics of a specific index as closely as possible. This means holding the same securities as the benchmark in similar proportions. In harder-to-trade assets, such as fixed income for example, passive ETFs may use sampling to achieve similar results. Remember, the goal of passive ETFs is not to outperform the index but to track its performance (and its risk exposures) as closely as possible.

ETF portfolios can also be actively managed by professional fund managers, often backed by teams of research analysts, who will decide on which securities to hold based on their own insights and the objectives of the investment strategy itself, rather than simply replicating the composition of their benchmark index. As a result, active ETFs can deviate quite widely from their benchmarks, allowing them to target excess returns and manage risks by adapting their portfolios to changing market conditions, or to target securities that can deliver specific investment outcomes, such as income generation, sustainability, or risk reduction. For example, an active bond ETF might shift its interest rate sensitivity based on the latest interest rate expectations, rather than simply replicating the interest rate exposure of its benchmark. Similarly, an active equity ETF will look to increase its exposure to securities that are expected to perform well in the future, rather than simply allocating higher weightings to those stocks that have performed well in the past.

Over time, skilled active ETF managers can potentially generate significant excess returns over and above their benchmarks, and provide targeted, research-driven access to a wide range of investment outcomes and opportunities across markets and asset classes.

How to use ETFs in your portfolio?

As a result of the efficient market access that they provide, investing in exchange traded funds can allow you to implement a range of liquid and cost-effective strategies in your portfolio, whether you’re looking to build a core investment exposure, capitalise on tactical opportunities, target returns from specific sector or regional exposures, or pursue different investment outcomes.

• Core portfolio building blocks ETFs are often used as foundational investments in portfolios. An ETF that invests broadly across major global stock markets, or that provides regional market exposure, for example, can serve as an effective core portfolio holding.
• Sector and regional exposures Investors can use ETFs to target specific sectors or regions, providing an efficient way to fine-tune your portfolio allocations based on market outlooks or your personal investment views.
• Tactical investing ETFs can allow you to move quickly in and out of positions to capitalise on short-term market opportunities. This flexibility can be attractive if you want to take advantage of market movements to implement changes in your portfolio allocation.
• Targeting specific outcomes ETF strategies can focus on generating a regular and consistent income, reducing the overall volatility of returns, or targeting access to specific investment themes, such as climate investing, or the growth in new technologies.

Investing in exchange traded funds – A highly versatile tool

Investing in ETFs – A highly versatile investing tool Investing in ETFs provides a liquid, transparent and cost-effective way to access an ever-increasing range of investment opportunities. It’s this versatility, market access and cost efficiency that makes ETFs so popular with investors. So, whether you’re new to ETF investing or an experienced professional, understanding how ETFs work – and the different types of ETFs that are available – can help you to realise the full potential of ETFs in your portfolio.