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Retail investors generally have two main approaches to gaining exposure to the stock market. The first involves investing in a small selection of individual stocks, but this concentrated strategy carries significant risk. A poor performance or failure of just one company can disproportionately affect the overall portfolio.
The second, more diversified method is through collective investments like exchange-traded funds (ETFs). These pool funds from multiple investors, with a professional managing the assets. This approach spreads risk across a variety of holdings.
Here’s an overview of how ETFs function, why they may be a good fit, and what to consider when incorporating them into a portfolio.
What is an Exchange-Traded Fund?
An ETF allows investors to participate in the stock and commodities markets without the need to select individual company stocks. Instead, ETFs track a group of key investments in a specific market, sector, or asset class, such as commodities.
ETFs emerged in the 1990s and became available on the London Stock Exchange in 2000. They’ve since gained popularity. In 2021, over £7 trillion was invested in ETFs globally, according to data from EPFR.
ETFs are particularly appealing to younger investors. Research from WisdomTree found that 36% of UK investors aged 18-34 hold ETFs, compared to just 5% of those aged 55 and above.
Types of ETFs
There are a wide variety of ETFs available. As of 2021, the London Stock Exchange had more than 1,500 ETFs from around 50 issuers. Globally, Statista reports there were approximately 8,500 ETFs in circulation in the same year.
ETFs can be created around almost any type of security or asset. For instance, stock ETFs focus on shares within a particular industry, such as healthcare. Bond ETFs invest in government or corporate debt, while currency ETFs focus on foreign exchange. Some ETFs combine multiple asset types, creating hybrid ETFs.
ETF vs. Index Tracker
Unlike unit trusts and tracker funds that are priced once daily, ETFs are traded on stock exchanges and have live, fluctuating prices. This allows for greater flexibility and liquidity compared to traditional index trackers, as ETFs can be bought and sold throughout normal trading hours.
What are Exchange-Traded Commodities?
Similar to ETFs, exchange-traded commodities (ETCs) track the performance of commodities like gold. Physical ETCs hold the commodity directly, such as gold bullion, while synthetic ETCs use derivatives to mirror price movements.
