What is an ETF, and why does every guide to passive investing recommend one? An ETF, or exchange-traded fund, is a fund that holds a basket of investments and trades on the stock exchange like a single share. With one purchase you can own a small piece of hundreds or thousands of companies.
In short
- An ETF is a fund that trades on the stock exchange, like a share.
- Most ETFs track an index, such as the MSCI World or the S&P 500.
- They are cheap: popular world ETFs cost 0.14% to 0.20% a year.
- In Europe, look for UCITS ETFs, which are regulated and widely available.
What is an ETF and how does it work?
Imagine you want to own the 1,300 or so largest companies in developed countries. Buying each one yourself would be expensive and impossible to manage. An ETF does it for you: the fund buys all of them in the right proportions, and you buy units of the fund.
When the companies in the fund rise in value, the ETF rises. When they pay dividends, the ETF either pays them out to you or reinvests them, depending on the version you choose. See accumulating vs distributing ETFs for the difference.
ETFs and indices
Most ETFs are passive: instead of a manager picking stocks, the fund copies an index. An index is simply a list of companies chosen by fixed rules. For example:
- MSCI World: large and mid-sized companies in 23 developed countries.
- FTSE All-World: developed and emerging markets together.
- S&P 500: 500 large US companies.
Because the fund only has to follow the list, it needs no expensive research team. That is why ETFs cost a fraction of traditional funds. To understand why tracking the market works so well, read index investing for Europeans.
Why ETFs are so popular
- Diversification: one ETF can spread your money across thousands of companies, so one company going bust barely matters.
- Low cost: yearly costs of 0.1% to 0.3% are common, compared with 1.5% or more for many actively managed funds.
- Transparency: you can see exactly what the fund holds.
- Flexibility: you can buy and sell any time the exchange is open, or invest automatically with a monthly savings plan.
What UCITS means for Europeans
UCITS is the EU’s set of rules for investment funds sold to the public. A UCITS ETF must diversify, keep investors’ assets separate and publish a Key Information Document (KID). Most ETFs sold in Europe are UCITS, and many are domiciled in Ireland for tax reasons.
European investors usually cannot buy US-listed ETFs, because those funds do not publish the KID that EU rules require. The good news is that UCITS versions exist for almost every popular index. See why Europeans can’t buy US ETFs and why Irish-domiciled ETFs are popular.
The risks to know
An ETF reduces the risk of picking the wrong company, but it does not remove market risk. If the whole stock market falls, a stock ETF falls with it. A global equity ETF can lose 30% or more in a bad year. That is why ETFs are best for money you can leave invested for many years.
Some ETFs are also far riskier than others. Leveraged, sector or thematic ETFs can swing much more than a broad world fund. Beginners are better served by one broad, low-cost fund.
How to buy your first ETF
- Open an account with a low-cost broker. See the best brokers for ETF investors.
- Choose one broad ETF, for example one of the best all-world ETFs.
- Search it by its ISIN, a 12-character code that identifies the exact fund.
- Buy once, or set up a monthly savings plan.
- Leave it alone and keep investing regularly.
For a full step-by-step plan, read how to start investing in Europe.
Sources
This article is for educational purposes only and is not financial or tax advice. Rules and prices change; check official sources or a qualified adviser before making decisions.