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ETF schoolLevel 1Beginner8 minUpdated What is an ETF and how does it work?
An ETF is a fund traded on an exchange: with one purchase you get a slice of everything the fund owns. This chapter covers the structure, pricing and UCITS regulation, as well as what an ETF gives you and what it doesn't remove.
One trade, many holdings
An ETF (Exchange-Traded Fund) is a fund that trades on an exchange like a share. When you buy one ETF unit, you own a proportional share of everything the fund holds.
In practice, one unit can give you ownership in thousands of companies across dozens of countries, or narrow exposure to a single industry. The structure is the same; the contents decide.
You and thousands of other investors buy ETF units on the exchange. Each unit is a fraction of the whole fund. You don't buy an individual security but a share of everything the fund owns.
Watch: what is an ETF?
If you'd like the topic summed up in a video, start here. The video covers the basic idea of an ETF and why the structure is so popular.
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Passive or active?
Most ETFs are passive index funds: they aim to replicate the return of an index as closely as possible, not to beat it. Some ETFs, however, are actively managed, which means a portfolio manager makes choices.
Why does the price stay right?
An ETF's price stays close to the value of its underlying assets (NAV) thanks to the creation and redemption mechanism. Large market participants can create new units by delivering a basket of securities that matches the index to the fund, or redeem units back into securities.
If the market price drifts above or below the value of the contents, there's an immediate incentive to close the gap. This is why an ETF is liquid and fairly priced at the same time.
What does UCITS mean?
Most of the ETFs available to European investors are UCITS funds. UCITS is an EU regulatory framework that sets common rules for funds.
- Diversification requirements: the fund may not concentrate too much of its assets in a single holding.
- Segregation of assets: investors' assets are held separately from the fund management company's own assets.
- Key information document: a comparable description of costs, risks and strategy must be published.
What the structure gives you
The popularity of ETFs isn't based on marketing but on the fact that the structure solves a few practical problems at once.
What risks remain
Diversification reduces the risk of any single company, but market risk always remains. If the whole market falls, a broadly diversified ETF falls too.
- Market risk: the value of the underlying assets can fall, and the decline can last a long time.
- Concentration risk: a narrow index can depend heavily on a few companies.
- Currency risk: with foreign holdings, the exchange rate affects the return in euros.
- Tracking risk: an ETF doesn't always track its index perfectly.
- Counterparty risk: in synthetic structures, the swap counterparty may fail to meet its obligations.
- Liquidity risk: in a thinly traded product, the spread can widen at exactly the wrong moment.
What an ETF doesn't do
This is the point that often goes unnoticed: the ETF wrapper doesn't improve the contents. If you buy narrow, expensive and badly timed exposure in ETF form, it is still narrow, expensive and badly timed.
This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns. The calculators and comparisons are illustrative.
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