What is an ETF?
Important information - This information isn’t personal advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in. If you’re not sure whether an investment is right for you please ask for financial advice.
An Exchange Traded Fund (ETF) is a basket of investments usually made up of shares and/or bonds. Funds are a ready-made investment portfolio run by a professional fund manager. They provide access to a diversified portfolio for usually a much lower cost than purchasing the individual investments yourself.
When you buy an ETF, you are buying a slice of the ETF’s underlying portfolio. Most ETFs track an index – a collection of securities that represent a certain sector or region. For example, the FTSE 100 is an index that represents the largest 100 companies in the UK.
All funds are professionally managed, including ETFs. However, ETFs are usually passive products as they track an index. This means that investment decisions are guided by the attempt to replicate the performance of an index as closely as possible. Whereas, for active funds the objective is to outperform their chosen index. This is why the fees are usually lower for passive ETFs compared to active funds.
Why invest in an ETF?
There are many aspects of an ETF that can make them an attractive proposition for investors.
They are a good diversifier, easily accessible and cost effective. ETFs have risen in popularity so that there are now over 10,000 ETFs available globally.
Investors in European ETFs benefit from the UCITS framework, which provides a high level of protection for investors in funds from across the EU. UCITS ETFs are identified by the “UCITS ETF” label in the fund name.
Investors should only invest if the ETF’s objectives are aligned with their own, and there’s a specific need for the type of investment being made. You should understand the specific risks before investing and regularly review it to ensure it remains right for you.
Easy to invest
ETFs are easy to understand and come in a huge range with over 10,000 available globally.
Highly regulated
Those with the UCITS label adhere to a high level of regulation providing investors with safeguards not provided by other ETPs.
Low cost
Providing access to many stocks and various industries usually at a low cost compared to standard funds.
Can I hold ETFs in my ISA, Fund and Share Account or SIPP?
Most UK ETFs can be bought and held within an HL ISA (including an HL LISA), HL Fund and Share Account or HL SIPP. To see if a particular ETF can be bought or held within an ISA, Fund and Share Account or SIPP, please view the ETF’s factsheet.
What does it cost to buy, sell or hold ETFs with Hargreaves Lansdown?
You can buy and sell ETFs online from £11.95 per deal, this might be cheaper for frequent traders. There are no dealing fees when you invest by Direct Debit (available on selected ETFs, with a minimum of £25 per month).
It's free to hold ETFs within the HL Fund and Share Account or Junior ISA. The annual charge to hold them in the HL Stocks and Shares ISA or SIPP is 0.45% (capped at £45 p.a. in the ISA and £200 p.a. in the SIPP). For the Lifetime ISA the annual charge is 0.25% (capped at £45 p.a.).
What are the risks associated with ETFs?
In addition to the risks associated by all ETPs, which can be viewed here, ETFs also encounter:
Index sampling risk – if the ETF uses an index sampling technique where it invests in a representative sample of shares or bonds that represent the index, there is the risk that the securities selected may not match the performance of the total index.
Counterparty risk – this occurs when a third party is involved with some aspect of running the ETF. For example, when ETFs use derivatives such as futures or options or when they are lending stock as part of a securities lending programme. If the counterparty (the third party) ran into financial difficulties, there is a chance that the ETF and subsequently the investor could lose money. This could involve larger costs to the ETF, the ETF could cease trading temporarily or, in the worst-case scenario, be wound up altogether.
Investors should understand the specific risks of an ETP before they invest, please see the KIID for full details.
How are ETF units created/redeemed?
ETFs and index funds are made up of units which are owned by investors. However, the way these units are created for each fund type is different.
When you invest in a index fund, the cash is given directly to the fund manager to buy the investments that make up the fund. In return you receive a certain number of units in the fund which represent a proportion of the total assets.
However, when you invest in an ETF, you buy it through the secondary market – a market where investors buy and sell securities. This means units in the ETF are sold between investors rather than directly via the fund manager. Unlike shares, ETF units don’t get onto the exchange via an initial public offering. Instead, ETFs rely on a creation/redemption mechanism.
ETF units available on the secondary market are already in existence, and the investor is taking them from someone else. Units are not created or redeemed on the secondary market. Instead, they are created by a group known as Authorised Participants (APs). APs are often large brokers/dealers, that are authorised by the ETF issuer to participate in the creation/redemption process.
An AP creates an ETF unit by first buying stocks to represent the index it’s looking to track. It then passes those stocks to the ETF issuer. The ETF issuer then provides the AP with an ETF unit in exchange for those stocks, which the AP then takes away and can sell to the market and to investors.
When redeeming an ETF, the unit is passed back to the AP. They can then swap the ETF unit with the original ETF issuer for the original stocks that they offered them.
What is UCITS?
UCITS (Undertakings for Collective Investment in Transferable Securities) is a set of voluntary rules which many ETFs follow. ETFs which are UCITS compliant must follow minimum standards - that includes holding a diversified portfolio, publishing clear guidance on their charges and taking steps to safeguard investors' money.
Some ETPs are not eligible for UCITS standards - including ETCs, ETNs and US-listed products. UCITS products are not necessarily safer, nor are non-UCITS products necessarily riskier, but if a product is not UCITS compliant you should take extra care in reading the relevant issuers' documents.
Are there additional expenses with ETFs?
ETFs can have low expense ratios but they are open to certain other costs. For example, stockbroker charges for the buying and selling of the ETF or costs relating to the management of an actively managed ETF. The bid-offer spread can also be a hidden cost for investors.
It’s important you read and review all important documents, including the KIID, of any investment you’re considering. You can find these on HL website on the share page for each ETF.
Whenever you buy or sell an ETF, there are two dates to understand: the transaction date and the settlement date. 'T' is used to represent the transaction date - the day you buy or sell units in the ETF. The settlement date represents when ownership of the investment is transferred and is two working days after a trade is placed. For example, this is how long it takes to get any cash for selling the ETF. The abbreviation T+2 refers to the settlement date of a security transaction that occurs on the transaction date.
Index funds and ETFs are both passive investments that offer investors exposure to markets around the world by tracking an underlying index, like the FTSE 100. However, there are differences between the two.
Index funds value and trade only once a day, usually at midday, so investors won’t know exactly what price they’re buying or selling at until after the trade’s taken place.
ETFs on the other hand are traded on a stock exchange, like shares. They also track an underlying index, but the prices of ETFs fluctuate through the trading day. The ability to trade ETFs throughout the day adds greater flexibility, however timing the market is a tricky, if not impossible, exercise.
Index funds are also typically single priced, meaning the buy and sell price is the same. Whereas ETFs have different buy and sell prices, known as the offer and bid respectively. The difference between the buy and sell price is called the bid/offer spread. A small bid/offer spread means investors should achieve a market price close to the value of the underlying investments. These spreads are managed by market makers, a designated broker-dealer firm that tracks an ETF’s value throughout the day.
Both index funds and ETFs have annual management charges that are paid to the company offering the investment. Their passive nature means they usually have lower annual management charges compared to active funds that aim to beat an index.
Dealing costs for index funds are zero on the HL platform, but this is not the case for ETFs. As they are treated and traded like shares, both a buy and sell instruction for an ETF is subject to the HL share dealing charges. The difference in dealing charges can be a key consideration when deciding if a index fund or ETF is right for a portfolio.
There is no charge from HL to hold ETPs within the HL Fund and Share Account or HL Junior ISA. The annual charge to hold ETPs in the HL ISA or SIPP is 0.45% (capped at £45 p.a. in the ISA and £200 p.a. in the SIPP).
Most indices follow the price of shares or bonds and are constructed so that the biggest, most widely traded securities are the largest holdings in the index. However, some indices are created to consider alternative behaviours or metrics. Smart Beta ETFs are investments that track these alternative indices and are commonly perceived as a blend between active and passive investing.
Smart Beta ETFs can focus on factors like dividend yield, company earnings or the volatility in the investment price. It’s important to understand how the index that the ETF is tracking is constructed and its ongoing selection process for securities, as there are a large variety of products in the market. Investors can usually find this information in the ETF’s Key Investor Information Document or on the Factsheet.
While uncommon, tracker funds might outperform their benchmarks on occasion. There are generally three possible reasons for this:
Tracking difference can occasionally be positive over shorter timeframes. This may be due to a fund pricing mismatch, which should be corrected over time and shouldn’t be a sign of sustained outperformance.
The fund is earning extra revenue from additional activities – for example, securities lending. That said, lending revenue rarely fully offsets charges.
The fund is tracking its index inaccurately. Possibly the fund is partially replicated and has struck lucky due to some small differences between the way the fund and the index is invested. However, imprecision can work both ways and there is also the potential for these funds to underperform more than should be expected, so investors should bear this in mind.
ETFs are normally set up as either income (also known as distributing) or accumulation. Income ETFs pay out dividends to holders as cash. Accumulation ETFs do not pay a dividend. Instead, the income is reinvested back into the ETF, with the aim to grow its value over time.
Our factsheets provide the latest information regarding an ETF’s dividends. Simply locate the ETF and view the 'dividends' section on the ‘at a glance’ tab. Please remember dividend payments can vary and are not guaranteed.