What is an ETF & how do they work?
With an ETF or exchange-traded fund, you can invest directly in a large number of shares with one investment. But what is an ETF, and how exactly does an ETF work? In this in-depth explanation, we'll tell you everything you need to know before you get started with ETFs!
What is an ETF?
An ETF or tracker tries to follow an underlying security as closely as possible. Many ETFs relate to a specific index: with an ETF, you can, for example, follow the price development of the AEX or S&P500. However, ETFs come in all shapes and sizes: for example, it is possible to track the price development of gold or Bitcoin.
You can trade ETFs on the stock exchange using a brokerage account. In this article, we discuss in more detail how you can invest in ETFs.
Do you want to start investing in ETFs? Compare the best brokers & start investing today:
How does an ETF work?
Let's start with an explanation of how an ETF works. When you buy an ETF, you indirectly become a co-owner of the value of the underlying securities.
For example, many ETFs invest in stocks. When you buy an ETF that invests in the 30 stocks included in the Dow Jones, you indirectly own a small piece of all these companies with the ETF. The aim of the ETF is then to replicate the price of this index as closely as possible.
Incidentally, there is sometimes a tracking error: the price of the ETF can then deviate slightly from the underlying index.
When is investing in ETFs wise?
Investing in ETFs allows you to track a market instead of trying to beat it. In practice, it is challenging to beat a market: many actively managed mutual funds underperform ETFs.
ETFs are a wise choice if you're looking for a way to invest without too much effort. Regularly investing a fixed amount in ETFs can build up wealth in the long term. ETFs are, therefore, a wise choice for all investors who have money to spare and are looking for a relatively stable investment.
Please note that there are significant differences between ETFs. You can limit your investment risks by picking a broad, well-diversified ETF. Therefore, conduct research before you invest money in an ETF! In this article, we examine in more detail whether it is wise to invest in ETFs.
Types of ETFs
ETFs come in all shapes and sizes. In this part of our ETF explanation, we explain the differences.
ETFs can track a variety of underlying assets. Most ETFs track a well-known index, such as the S&P 500. However, you can also invest in bonds, commodities and currencies with an ETF. With an inverse ETF, you can also speculate on decreasing prices.
Accumulating or distributing
When an ETF invests in stocks, you can sometimes choose between an accumulating and a distributing version. With an accumulating ETF, the dividends are reinvested, while with a distributing version, the dividends are paid out. I prefer accumulating funds to benefit from the 'interest on interest' effect. Read more about it here.
Physical or synthetic
Many ETFs buy the underlying securities: with physical ETFs you know 100% what you are investing in. However, some funds are synthetic, meaning they try to replicate the underlying price through derivatives.
With or without leverage
You can also choose to invest in a leveraged ETF: your profits and losses can then add up quickly. For most investors, choosing an unleveraged ETF is the best choice, as it will help you limit your risk.
Advantages of ETFs
- Spreading your risks: You can invest in hundreds of shares at once with an ETF. This allows you to spread your risks even with a small amount of money.
- Low Cost: Compared to traditional mutual funds, the costs of ETFs are low. The average costs are around 0.3%.
- Flexible: ETFs are traded on the exchange. This allows you to sell your participation at any time at the prevailing price.
- Exotic markets: with an ETF, you can access more exotic markets that are otherwise inaccessible.
- Accessible: investing in ETFs is also accessible for novice investors. The required knowledge levels for ETFs are lower than for single shares.
Do you want to read more about the benefits of ETFs in more detail? Then read this article!
Disadvantages of ETFs
- Little control: when you buy shares, you can 100% determine what you invest in. With ETFs, you have to relinquish that control.
- Limited return: you limit your risks and chances of a substantial return. Single shares can sometimes generate very high returns.
- Liquidity: Unfamiliar ETFs may have low liquidity, which makes them hard to sell.
- Dividend leakage: You can lose part of your return due to imperfect tax arrangements.
- Market risk: you can still lose money with ETFs due to a falling market.
Would you like to read more about the disadvantages of ETFs in more detail? Then read this article.
What can you invest in with ETFs?
You can invest in almost all investment products with ETFs. This part of the article discusses some creative and less creative options. Do you want to know more about how you invest in a specific security with an ETF? Then click through, and we'll show you how to do this right away!
- S&P500: Investing in the S&P 500 with an ETF is very popular.
- Gold: you can also track the price of gold with an ETF.
- Emerging Markets: Invest in emerging economies with ETFs.
- Cryptos: You can also invest in cryptos with ETFs.
- Bitcoin: track the Bitcoin price through an ETF.
- High Dividend: Invest in ETFs that pay a high dividend.
How do you select the best ETF?
ETFs have the image of being 'easy investment products'. You indeed need less knowledge for ETF investments, but this does not alter the fact that you should do enough research into the ETF you want to invest in. In any case, pay attention to the following factors:
- Diversification: Does the ETF help you spread your risk across different securities?
- Fees: do you pay low fees on the fund?
- Liquidity: does the fund have a high trading volume?
- Dividend leakage: how does the fund deal with dividends?
- Return: how much return does the ETF generate?
- Tracking error: is the ETF accurate in tracking the index?
Ultimately, what the best ETF is depended strongly on your own wishes & preferences. For example, some investors find high returns important, while other investors prefer a more stable investment. Are you looking for inspiration? These articles can help you select attractive ETFs:
- Which ETF is the best to buy?
- What are the best DEGIRO core selection ETFs?
What is the risk of investing in ETFs?
ETFs have a reputation for carrying limited risk. It is true that diversification leads to more limited risks, but this does not alter the fact that investing always entails risks.
Because ETFs are passively managed, they never actively respond to market events. A stock market crash or company takeover can, therefore, directly influence the price of an ETF. You can somewhat limit your risks of these unexpected events by entering the market at different times.
In this article, you can read more about the risks of investing in ETFs.
How much does investing in ETFs cost?
When investing in ETFs, you should consider the following costs:
- Transaction Fees: You pay fees to your broker when you buy or sell an ETF. This is not the case when you buy an ETF from DEGIRO's core selection.
- Spread: There is never a perfect balance between supply and demand. This difference is also known as the spread and causes your costs to increase.
- Management costs: the fund charges so-called management costs. This is a percentage that is calculated annually on the invested capital.
Frequently Asked Questions about ETFs
Trackers and ETFs are actually synonyms: in both cases, the investment products track an underlying index.
Investing in ETFs is not free: you always pay management costs and a spread. In some cases, you also pay transaction costs to your broker. It can be wise to compare different brokers to lower your ETF trading fees.
ETFs are a great entry-level investment for beginners. With a well-diversified ETF, you can respond to the average price development within a certain market. However, it is important to read up sufficiently. Only invest with money you can afford to lose & only invest in ETFs you understand!
There is a fixed time for which you must hold an ETF, as you can buy and sell them at any time. However, when you hold ETFs for a longer period of time, the chances of success increase. Time after all is every investor's best friend!
ETFs are freely tradable on the stock exchange. You can, therefore, immediately sell an ETF through your broker. Make sure you invest in ETFs with sufficient liquidity: some ETFs do not have enough buyers and sellers, which can make selling difficult.
The amount of the return fluctuates strongly and, of course, also depends on the type of ETF you invest in. If you invest in a broad, well-diversified EFT, you could achieve an 8 per cent return over a long period. This can be a nice prediction for the future but remember: past results are no guarantee for the future.
This often depends on your broker and the transaction costs they charge. With some brokers, you can trade ETFs without fixed commissions: you can then invest in an ETF for as little as $ 100.
Try trading risk free?
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