An exchange-traded fund (ETF) is a type of fund that is made up of a pool of securities/stocks and trades on an exchange, the same as how individual stocks trade. The main difference is that ETFs are made up of multiple underlying assets rather than one individual stock, very similar to an index fund. These underlying assets can include all investment types, such as individual stocks, commodities, and bonds. For this reason, many retail investors choose to invest in ETFs to enhance their diversification by investing indirectly in multiple companies. In recent years ETFs have become increasingly popular, with total cash invested in ETFs reaching $9.94 trillion in 2021 (up from $0.2 trillion in 2003).
Whilst known for their diversification, you can also pick specific ETFs that concentrate on a particular sector, geography, or asset class, for example, a US-only ETF would be made up of companies solely from the US such as Apple and Amazon. Or perhaps a green energy ETF which specialised in renewable technologies.
Another reason why ETFs are attractive to investors is their low fees when compared with the cost of buying individual stocks. For example, Vanguard’s Total Stock Market (VTI) ETF has an ongoing expense ratio of 0.03% which is predominantly made up of management fees paid to Vanguard as the investment manager and is likely to be significantly less than paying stamp duty and commission as you do when buying individual stocks - this is subject to where the investor resides though.
The share price of an ETF will fluctuate throughout the trading day based on the volume bought and sold on the exchange. This differs from a mutual fund, which does not trade throughout the trading day on an exchange but instead is traded once per day after the market has closed.
ETFs can either be passive or active. A passive ETF would aim to follow and replicate the performance of the wider market by tracking an index, such as the S&P 500 or FTSE 100. An active ETF has a portfolio manager responsible for picking the securities that make up that particular ETF. Active ETFs can include the following: Bond ETFs (regular income provided to investors based on interest payments and performance of the underlying bond, which can be government, corporate or municipal bonds); Stock ETFs; Commodity ETFs; Currency ETFs.
Example ETF – Vanguard Total Stock Market (VTI):
VTI is one of the most popular ETFs for individuals to invest in, based on its longstanding history (est. 2001) and strong historic performance (+8.63% annual returns since inception). Its popularity is evident through its size, with total Assets Under Management (AUM) currently at $1.2 trillion (total value of commitments worldwide).
Along with the diversification, the reason ETFs are attractive is their low fees, with the VTI ETF having an expense ratio of just 0.03% - the ongoing charge of being invested in the fund.
As with many other ETFs, VTI’s strategy is to replicate the returns of the US stock market and does so by comprising of over 4,000 individual stocks with mega-cap companies accounting for the majority of them (the top 5 holdings include Apple, Microsoft, Alphabet (Google), and Amazon). The final point to note on VTI is the sector breakdown which can be found on Vanguard’s information page. VTI’s equity sector construction includes a 26.40% weighting to technology-based companies, 14.80% Consumer Discretionary, 13.30% Health Care, 12.80% Industrials, and 11.10% to companies in the financial sector.
Source: Vangaurd.com
