What is an ETF and how does it work?

A fund pools many people’s money and invests it for them. An ETF is a fund whose shares are listed on a stock exchange, so they are bought and sold through a share-dealing account, ISA or SIPP at the price on the exchange, at any time the market is open.

Most ETFs track an index, such as the FTSE 100 or a world index, either by holding the shares in it or by using contracts that pay the index’s return. A smaller number are actively managed.

Unit trusts and OEICs are bought from and sold back to the fund manager, usually once a day at a price set after the market closes. ETF shares change hands on the exchange throughout the day, so the price depends on the market at that moment.

Investment trusts also trade on the stock exchange, but they are companies with a fixed number of shares, and their share price can move well above or below the value of what they own. An ETF’s price usually stays close to the value of its holdings, because large dealers create or cancel ETF shares when the two drift apart.

Three separate costs apply:

Many ETFs come in two versions. Accumulating (“Acc”) shares keep dividends and interest inside the fund, so they show up as a rising price. Distributing (“Dist”) shares pay them out as cash, usually a few times a year.

Most ETFs sold to UK investors are UCITS funds — a European standard with rules on spreading risk — usually based in Ireland or Luxembourg. The same ETF can be listed several times, in pounds, dollars or other currencies, each with its own ticker.

ETFs listed in the US usually do not publish the key information document UK rules require, so most UK platforms do not offer them to individual investors.

Many ETFs can be held in a stocks and shares ISA, where income and gains are free of UK tax, or in a SIPP. The platform shows which ETFs it offers in each account.

An ETF that tracks a market falls when that market falls. Leveraged and inverse ETFs, which multiply or reverse daily moves, behave very differently over longer periods from an ordinary tracker.

FSCS protection can cover some losses if a UK-authorised firm fails; it does not cover falls in the value of investments. Capital at risk. Past performance is not a guide to future returns. The value of investments can fall as well as rise.