For anyone looking at how to invest in ETFs, the following tale is a good place to start.
In 2007 famous investor Warren Buffett made a $1m bet with a hedge fund called Protégé Partners.
Buffett said that in the following ten years, a fund tracking the S&P 500 index would outperform Protégé.
All Buffett had to do was invest and come back 10 years later to see what happened. Along the way he’d be charged a fee of less than 1% per year.
By contrast, the hedge fund would be dipping in and out of the market, regularly buying and selling shares and charging its clients huge fees in the process.
Buffett won the bet and in doing so lent credence to the claim that fund trackers, particularly ETFs, are one of the best options available to the average investor.
How do ETFs work?
We hear a lot about them but, for beginners, the first question is probably — what is an ETF?
ETF stands for ‘exchange-traded fund’. As the name suggests, they are funds traded on a stock exchange, just as most traded shares are. This is not the case with lots of funds (more on this later).
Most popular ETFs track an index, like the S&P 500. If you’re unsure what an index is, then think of it as a group of stocks that investors have put together, usually as a means of gauging how a particular market is performing.
The S&P 500, for example, is made up of the 500 largest companies on US stock markets. Grouping them together and examining their collective performance can provide some useful insights into how the market is performing.
But rather than being for analytical purposes, an ETF actually lets you track the performance of those companies. So if you buy ETFs that track the S&P 500, it’s almost like being invested in all 500 of those companies. The result is your investment will rise in fall in line with the index.
The logic behind doing this is that lots of investors think stock picking is too risky or not even worth the effort. By buying individual stocks they can end up seeing fewer gains than the market has overall.
That’s exactly what happened with Buffett’s bet. The hedge fund tried to pick stocks and ended up underperforming the index. So despite the huge amount of time and effort they put in, they would’ve been better off just buying an ETF and doing nothing.
Are ETFs a good investment?
That speaks to another factor which makes ETFs an attractive investment.
Even if you are a successful stock picker, finding and analysing investments is a long-winded process. And as Protégé’s performance shows, it’s not even guaranteed you’ll succeed.
The result is lots of investors prefer to simply put their money into ETFs.
If you look back over the past decades, this hasn’t been a bad option to take. Major indices, like the S&P 500 or the UK 100, have provided solid returns to investors. So for what was effectively very little effort, you could have enjoyed a simple way of making your wealth grow.
The downsides are that you are unlikely to see the sorts of returns that some stock pickers do. Major indices have tended to see increases over time but there are, almost by definition, going to be companies that outperform them.
Another thing to be wary of is market crashes. For instance, the UK 100 struggled for a long time to recover from a market crash in the early 2000s. That may not be a problem if you’re happy to wait it out, just know that you may have to wait a long time for a recovery to happen.
Are ETFs good for beginners?
ETFs are usually considered a good option for new investors.
Stock picking is not the easiest thing to do and if you don’t have time to dedicate to it then investing in an ETF is probably going to be a much simpler option.
The potential problem is to think ETFs provide a guaranteed return as some new investors do seem to believe.
Markets can always go south and stay that way for a long time, so just because some ETFs’ recent performance has been strong, it doesn’t mean things will continue that way forever.
New investors can also get spooked by crashes and sell off when they happen, meaning they can wipe out the gains they’ve seen up until then.
In short, ETFs can be a good option for investors who are starting out, just as they can be for investors with years of experience.
But they do not provide guaranteed returns and you still need to understand the risks that come with them. Not doing so can lead to losing money just as you would with stock picking.
Learn more on how to start investing with our investing in stocks for beginners guide.
Are ETFs good for long-term investing?
Like most investments, ETFs have historically performed better when held for a prolonged period of time.
In fact, this is arguably doubly the case for ETFs. Because they nearly always track a group of companies, it’s very unlikely you’ll see a sudden spike in price if you hold one, unless a significant portion of those companies also jumps.
The reason for this is that an index may rise substantially over a prolonged period of time but is unlikely to do so very suddenly. By contrast, they can crash in a single day.
Individual stocks are different in this regard too as unexpected positive news can often lead to a firm seeing substantial share price increases in a short period of time.
That’s not to suggest you should buy stocks on this basis, but the reality is it can happen in a way it’s unlikely to with an ETF.
As a result, it’s much more likely you’ll see a higher return by investing in ETFs for the long-run, as opposed to just trying to make a quick buck with them.
ETFs and dividends
Arguably the most important thing you need to know about ETFs is their treatment of dividends.
ETFs can have holdings in hundreds of companies and the likelihood is some of them will pay dividends.
The company that has issued the ETF has two choices as a result:
- They can distribute the dividends they receive to any ETF holders.
- They can keep the dividends and reinvest them.
If you choose to keep the dividends as income then be aware that your total return, over a prolonged period of time, is likely to be substantially reduced.
One study by GFM Asset Management found that 75% of the S&P 500’s returns from 1980 to 2019 came from reinvested dividends.
That’s a huge proportion and by choosing to take dividend income from your ETF, it’s what you could end up missing out on.
Obviously you may have good reasons why you want income, as opposed to share price appreciation.
But if you are investing in ETFs for the long-run, and have no plans to use any of the gains that may come from those investments, then it becomes hard to understand why you would want your dividend income paid out to you.
And if you want to know what the ETF your investing in does with regard to income, check its full title or look at the issuer’s website. An ETF that distributes income usually has ‘Dist.’ or ‘Inc’ in its full name. An ETF that reinvests income usually has ‘Acc.’ in its name.
Learn more:
What are dividends?
Dividend stocks to invest in
Can you make money with ETFs?
Investing in ETFs that track major indices and holding them for a prolonged period of time has historically provided investors with profitable returns.
But there is a difference between realised and unrealised returns. The value of your ETFs may increase dramatically but if you don’t sell them, you won’t realise a gain.
And as we’ve seen, indices can crash in value. Even if it's a semi-rare event, if you are forced to sell after one has happened then you could end up losing money.
So even if ETFs have historically provided good returns to some investors, there’s no guarantee they will for you.
How much should you invest in ETFs?
Investors like to have cut and dry answers to questions like these but, sadly, they’re nearly never forthcoming.
Some people do decide to invest solely in index-tracking ETFs.
Given the diversification they offer, this isn’t necessarily an unwise thing to do. And as Buffett’s bet shows, you can invest in them, do nothing for a long time and potentially see a solid return.
Other people like to keep ETFs at the core of their portfolio but supplement them with trusts, funds or individual stocks.
Ultimately how much you want to invest will come down to your own preferences and risk tolerance. Only you can know what those things are and so it’s really up to you to consider if you do want to invest in ETFs and how much of your portfolio you should allocate to them.
How to buy ETFs
ETFs are listed on exchanges and trade in pretty much exactly the same way stocks do.
That means the buying process is effectively identical to investing in individual companies.
You have to:
- Identify an ETF or ETFs that you want to invest in.
- Find a broker or stock trading app that offers them.
- Open a brokerage account with that company.
- Deposit funds into your account.
- Use the funds to buy the ETF(s) that you want to invest in.
How are ETFs taxed?
You need to think about tax on ETFs from a couple of viewpoints.
The first is how it will affect you individually. If you invest in an ETF, it rises in value and you sell at a profit, that constitutes a capital gain.
Unless you made that investment in an ISA account or SIPP, that capital gain may be subject to capital gains tax.
The same is true of any dividends you receive through an ETF.
Investments you make via an ISA or SIPP would mean dividends won’t be subject to UK tax. But if you made them in a general investment account then they may be.
You do have annual government allowances for both capital gains and dividend tax, so it may be you end up not having to pay tax on your ETF investments, even if they’re made through a regular account.
As you can probably tell, tax on investment income is a complicated subject, so make sure you’re familiar with how it could impact you before you buy anything.
ETFs vs index funds
Something that can get confusing for investors is the distinction between ETFs and index funds.
The main reason for that is the terms are often used interchangeably when talking about index-tracking ETFs.
But there is actually a distinction between them. Index funds are pooled funds which lots of investors contribute to.
Like an index ETF, their goal is to track the performance of an index, like the S&P 500.
The difference is they are not exchange-traded, so you can’t buy ‘shares’ in an index fund from somewhere like the London Stock Exchange.
That means you can’t buy and sell your index fund holdings throughout market hours as you could with an ETF. Instead there is usually a set point in the day when you can cash out your fund holdings.
They are also open ended, which means the company managing the fund will sell you newly created units when you want to buy into the fund and then redeem them if you want to cash out.
By contrast, ETFs trade like stocks, meaning you are unlikely to be purchasing them directly from the ETF issuer but another investor that wants to sell their shares.
ETFs vs stocks
The goal of an ETF is to give you exposure to a wide range of companies.
Investing in an ETF tracking the S&P 500, for example, means you have exposure to the companies in that index.
Stocks represent ownership in individual businesses.
That means your exposure is to the performance of those companies and not the broader range of assets an ETF holding gives you.
Are ETFs safer than investing in stocks?
The result is that an individual stock is likely to carry more investment risk than an ETF does.
If the company you have shares in does badly, and you have no other investments, then you’re likely to lose a lot of money.
By contrast, the diversification that a broad market ETF offers means one company doing badly isn’t likely to hit you as hard.
The downside is that the opposite is also true.
Company shares can do well but you won’t benefit as much from those gains if it’s just one of many companies you have exposure to via an ETF.
ETFs vs mutual funds
Mutual funds are pools of money that lots investors contribute to, passive index funds are one version of them. The alternative is an active mutual fund with a pool of money managed by financial professionals.
The difference between this and an index ETF is the fund managers will usually pick individual assets, like company shares or government bonds, to invest in.
That’s not the same as index ETFs or index funds, which simply attempt to track the performance of an underlying index.
As such, a mutual fund is less likely to see its performance rise or fall in line with a specific market, as it would if it were only tracking an index.
Mutual funds are also not listed on an exchange, so you cannot buy and sell shares in them in the same manner as you would with an ETF.
ETFs vs investment trusts
Investment trusts are exchange-listed companies that invest in other assets.
Like a mutual fund, an investment trust is managed by financial professionals who attempt to pick stocks or other assets in order to generate a return for their shareholders.
The difference between trusts and funds lies in their structure. Shares in investment trusts are exchange-traded, meaning you can buy and sell them in much the same way you would invest in an ETF.
But as investment trusts are managed by people attempting to pick stocks, they are different to an ETF, which is most likely just tracking an index.
They are also closed-ended, meaning a set number of investment trust shares are issued and these are the ones you see trading on an exchange.
In contrast, mutual funds or index funds are usually open-ended, meaning they’ll issue or redeem shares based on when people buy and sell shares in them.
ETF investing strategies
ETFs are used by most people as a simple investment option. That means the sort of in-depth analysis and strategising you see with stock picking isn’t on the same level.
But that doesn’t mean you should be complacent.
ETFs do carry risks with them and you need to think about how you want to invest in them before you do anything.
One important example of this is, as mentioned, whether or not you should take dividends from them. But there are other factors to think about too.
Buy and hold ETF strategy
The simplest thing to do with an ETF is, like Warren Buffett in our introduction, invest and hold for the long-run.
That doesn’t necessarily mean you put in a lump sum and leave it.
Lots of people will top up their ETF holdings regularly from their salary, bonuses or both.
One of the benefits of doing this is that you can end up smoothing out the rises and falls in the market, something that’s usually known as ‘pound-cost averaging’.
Core-Satellite ETF strategy
Another popular ETF strategy is to have ETFs as the core of your portfolio and stocks or other assets as the remainder.
For example, UK investors might like to have half of their portfolio in a UK 100 ETF and then the remaining half split between investment trusts and individual stocks.
If you do go down this route then you are going to have to pick stocks, which means both exposing yourself to riskier assets and the need to do the extra leg-work of finding shares to buy. Have a read of our ‘how to invest in stocks’ guide if you are considering this.
Another option is to have the non-ETF part of your portfolio solely in investment trusts or actively managed funds.
Again, the risk here is the people managing those companies won’t do a good job at picking assets to invest in and you end up doing worse than you would have if you only bought ETFs.
One way to identify investment trusts to buy is to look at the aims and approach to investing taken by the managers of any trusts you’re thinking of investing in.
For example, the Scottish Mortgage and City of London investment trusts have regularly provided index-beating returns over the past ten years through very different processes, holdings and stock selection criteria
How to value ETFs
Some investors think that you can look at the index an ETF is tracking and immediately know what its value is. Things aren’t quite so simple.
Like other funds, ETFs have a NAV or ‘net asset value’.
This is usually provided by the ETF issuer on their website or in any documentation they publish. It tells you what the value of the fund is when you take all of its cash and stock holdings and subtract any liabilities it has.
NAV is usually expressed on a per share basis, meaning you have to divide the number you reach by doing the above calculation by the total number of ETF shares in issuance.
An ETF’s NAV is usually in line with its share price but that’s not always the case, so it can be worth looking at it.
Other factors you need to consider are tracking error and fees.
Contrary to popular wisdom, ETFs do not exactly match the performance of an index they are seeking to track and often don’t even hold all of the stocks in one.
The result is something known as tracking error, which is the difference between the performance of the ETF and the index it tracks. Even a seemingly minor deviation, which could be under 1%, is worth being aware of.
After all, you probably want the ETF you're investing to track an index. If it’s deviating substantially from that then you have to ask what’s going on.
That’s not to say you should obsess over it. Most ETFs will have a tracking error, so it’s not a huge red flag if there is one. Just make sure it’s not totally out of whack with the index.
Fees are also important. Although they tend to be lower than investment trusts or funds for broad market ETFs, fees are always going to be a drain on your return. It’s hard to think of an area of life where you would pay for something and not want to know about it, so ETFs shouldn’t be any different. When it comes to thematic ETFs in niche areas like tracking cannabis companies or green energy, those fees can really climb.
When should I sell an ETF?
This is another one of those questions where investors like to have a silver bullet answer. Sadly there isn’t one.
It may be better to think about this in terms of how you should invest in ETFs.
The historical performance of ETFs shows it’s nearly always better to invest and hold for the long-run than try to make a quick gain from them.
Selling then depends on your own goals and circumstances. You may want to hold ETFs all the way until your retirement and use them as part of your pension pot. Perhaps it’s just a rainy day event in the distant future that you want to set aside investments for.
The big danger here is, once again, market crashes. For instance, if you had been planning on retiring in March 2020 and had invested heavily in index tracking ETFs for it, then you were probably going to be disappointed.
So if you do have a particular goal in mind for any ETF investments you have, remember the market may have other plans for you.
Learn more on how to identify the ideal time to sell part of your investments with our 'How to sell shares' guide.
ARK ETF
One thing that’s risen in popularity over the past few years is the idea of active ETFs.
Perhaps the most popular one in the US in 2021 is the ARK ETF managed by Cathie Wood.
There are a few things to be aware of here.
First of all, these are not index-tracking. ARK, for example, is a fund managed by Wood that picks different stocks to invest in. That means it arguably doesn’t provide the same sort of security as a regular index-tracking ETF.
Another thing is that the fees active ETFs charge aren’t low. In fact, ARK’s fees are more than double those charged by some UK investment trusts.
Lastly, a lot of active ETFs are US-listed. UK financial regulation requires ETF issuers to provide a specific document, called a key investor information document (or ‘KIID’), to retail investors.
As of 2021, US ETF issuers aren’t required to do this and so they don't do it, meaning they are effectively inaccessible to UK investors.
What ETFs are popular buys on Freetrade
- iShares Global Clean Energy UCITS ETF (Dist)
- Vanguard S&P 500 UCITS ETF (Dist.)
- Vanguard FTSE All World UCITS ETF (Dist.)
- Vanguard S&P 500 UCITS ETF USD (Acc.)
- iShares Core FTSE 100 UCITS ETF (Dist.)
- INVESCO NASDAQ 100 UCITS ETF (Dist.)
- Vanguard FTSE All-World UCITS ETF USD (Acc.)
- iShares S&P 500 UCITS ETF (Dist.)
- iShares UK Dividend UCITS ETF (Dist.)
- Vanguard FTSE 100 UCITS ETF (Dist.)
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