7 questions to consider before investing in ETFs

• Different ETFs have different objectives, costs, risks, and features, so it's worth understanding how a fund works before investing.
• Key things to check include what an ETF holds, how it's run, what it costs, and how easily it trades.
• Like any investment, ETFs carry risk, and past performance is not a guide to future returns.

“Marketing Communication. The value of your investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.” 

ETFs are commonly used to invest in a range of markets and asset classes. But different ETFs have different objectives, costs, risks, and features, so it's worth understanding how a fund works before investing.

The questions below cover some of the things people most often ask about ETFs, from how they work to what they cost and things worth weighing up.

1. What is an ETF?

An ETF (exchange traded fund) is a fund that holds a basket of investments and trades on an exchange. Buying shares in an ETF gives you exposure to the fund's underlying investments. Some ETFs cover a wide range of holdings in a single trade, often by tracking a major index. Others focus on a narrower market, sector, theme, or strategy.

2. What kind of ETF is it?

Two things shape how any ETF behaves: what it holds, and how it's run.

What it holds

Every ETF invests in a particular asset class, the broad type of investment it holds, such as company shares (equities), bonds (fixed income), or commodities like gold. Some hold a mix. What a fund holds drives much of its risk and return: a broad equity ETF tends to move more sharply than a government bond ETF, and a fund concentrated in one sector or country can behave very differently from one spread across global markets. Two ETFs can both be equity ETFs and still carry quite different risks.

How it’s run

An index ETF aims to track a market by following a benchmark, a set list of investments such as a major share index, so its goal is to match that market rather than beat it. This approach often comes with lower charges. An active ETF is run by a manager who chooses the investments in pursuit of a stated objective, which can mean higher charges, and returns that depend more on the manager's decisions than on the market alone.

Themes cut across both. A thematic ETF, focused on something like technology or climate, is usually a narrower, more concentrated way to invest, so it can carry higher risk than a broad-market fund, even when it tracks an index.

3. How can I check an ETF's objective and risks?

Understanding the objective

An ETF's objective explains what it aims to invest in and how it's run. An index ETF aims to track a benchmark, so the way that benchmark is built can affect how the fund behaves and performs. An active ETF aims to meet a stated objective through the manager's investment decisions, rather than simply tracking a market.

Understanding the risks

Like all investments, ETFs carry risk. The main risks come from what the fund aims to do and the investments it holds. Broader risks, such as currency movements, interest rate changes, and wider economic conditions, also apply.

Two risks are worth knowing about with ETFs specifically:

Tracking difference

An index ETF may not match its benchmark exactly, because costs and the way the fund is managed can cause small gaps between the two.

Premium or discount to NAV

An ETF's market price can drift slightly above or below the value of its underlying investments (its net asset value, or NAV), particularly when markets are volatile. This can affect the price you get when you buy or sell.

4. How might you use ETFs?

People use ETFs in lots of different ways. Some of the most common include:

Spreading risk

A single ETF can give you exposure to many investments at once, which can spread your money across different companies, sectors, and regions, so you're less reliant on any one of them.

How widely a fund spreads risk varies from one ETF to another, and diversification doesn't prevent losses.

Reaching different markets

ETFs can provide exposure to markets that may be harder to access directly, such as commodities or overseas markets. These can bring extra risks, costs, and liquidity considerations, so they're not always straightforward.

Investing regularly

Some platforms let you invest smaller amounts on a regular basis, or buy part of a share at a time (sometimes called fractional investing), though availability, fees, and minimum amounts vary by platform.

5. What are the costs of investing in ETFs?

Common costs of investing in ETFs include:

Ongoing charges

The ongoing cost of running the ETF, such as management and administrative expenses. These are usually reflected in the fund's performance over time rather than billed to you directly.

Platform or custody fees

Some platforms or brokers charge a fee for holding your investments or providing account services. These vary by provider, and some platforms may not charge them at all.

Brokerage

A broker, bank, or investment platform may charge a fee when you buy or sell an ETF. Fees, and the ways you can trade, vary by country and provider.

Bid/ask spread

When you buy or sell an ETF, there's often a small gap between the highest price a buyer will pay (the "bid") and the lowest price a seller will accept (the "ask"). That gap is the spread, and it can vary depending on the ETF, its underlying holdings, and market conditions.

Beyond these costs, tax can also affect what you keep, and it works differently: it depends on you, not just the fund. How an ETF is taxed varies with where you live, where the fund is based, how you hold it, and whether it pays out or reinvests income. It's worth understanding how a particular ETF would be taxed in your situation before you invest.

6. How is ETF performance measured?

You can compare an ETF's performance with its stated objective or benchmark, but past performance is not a guide to future returns.

For an index ETF, the key measure is its tracking difference: how closely the fund's return has matched the index it aims to track. A fund usually falls slightly short of its index, mainly because of costs.

For an active ETF, there's no index to match, so you'd look instead at how the fund has done against its stated objective and the level of risk it took to get there.

A few things affect how closely an index ETF tracks its benchmark, including the fund's running costs, how it's managed day to day, and how it handles changes to the index it follows.

You may also see the term “tracking error,” a more technical measure of how consistently a fund has tracked its index over time, rather than how far behind or ahead it ended up.

7. What is liquidity, and why does it matter for ETFs?

Liquidity is how easily you can buy or sell an investment without much affecting its price. For ETFs, it's worth knowing that it works on two levels.

The first is how actively the ETF itself is traded, in other words, how many buyers and sellers there are for its shares day to day.

The second is how easily the investments inside the ETF can be bought and sold. This matters because it can support trading in the ETF even when the fund itself isn't heavily traded. An ETF with relatively few buyers and sellers can still trade reasonably well if the investments it holds are easy to buy and sell.

Either way, how easily you can trade, and the price you get, can still vary with market conditions and the size of your trade.