Exchange-Traded Funds: A step-by-step guide

Moneymagpie Team 8th Jun 2023 10 Comments

Reading Time: 6 minutes

Exchange-Traded Funds (ETFs) provide a cheap, easy, and relatively reliable way to invest in the stock market. (Well, as reliable as possible – remember, any investment means you could lose money as well as make it).

They’re easy to buy and sell, with typically lower transaction and account fees than managed funds.

So, what are ETFs? How do they work – and why are they cheaper than other investments?

This article covers everything you need to know – including a step-by-step guide on how to invest in them.

• What are they?
• Why are ETFs a good investment?
• ETFs: How do they work?
• How do I set up my ETF?
• Don’t forget to protect it from tax – if you can
• How do I track the progress of my ETF?

 

What are they?

ETFs mimic index–tracking funds in terms of how they work. They track selected parts of the stock market and your investment goes up or down depending on the performance of the ETF selection.

You can track commodities, markets like the FTSE 100, or even the performance of entire countries or market types. For example, you might want to track leading countries or take a little more risk – for more reward potential – by tracking ‘emerging market’ countries.

The passive investment nature of ETFs make them really cheap to invest in. A computer tracks the market – there’s no fund manager actively moving money around.

The big difference between ETFs and index-tracker funds

ETFs are companies in their own right. That means they’re traded like individual shares – so you need to go through either a stockbroker or online stockbroking platform to invest in them. Don’t worry, we’ll explain how to do that below!

They don’t make any products like other companies you can buy shares in, like BT or Tesco. Instead, they make money investing in other shares.

Instead of investing in individual companies, an ETF buys shares across the selected market. This spreads the risk, as gains and losses average out. For example, a precious metal ETF would buy shares from gold, silver, and other mining companies.

If all those companies do well, the ETF value goes up, too. That’s because the individual shares held by the ETF company, in these mining companies, have all done well. If they all do badly, the ETF value goes down.

Usually, however, some go up and some go down. Over time, this typically means an overall increase in value.

Sign Up – Newsletter

 

Why are ETFs a good investment?

The inexpensive ongoing costs of investing in ETFs make them ideal compared to managed funds.

High-cost funds may have a better track record for investors (but not always, and that’s not guaranteed) – but you have to pay the fees whether it’s been a good or bad year. So, if your portfolio loses money, you’re still paying a lot to fund managers. Even in good years, the percentage-based commission fees will eat into your profits.

An ETF investment has a much lower fee – meaning you get to keep more of your profits AND won’t be hit with huge fees even in low-performance years.

The simplicity of ETFs make them ideal for new investors, too. The funds invest into a stock market index, commodity, country, or market type directly: there are no complex layers to the investments.

Prices update every 15 seconds, too, as a result it’s easy to keep a real-time view of investments and help you determine the best time to buy or sell an ETF fund. Traditional fund investments, on the other hand, only update once a day.

 

ETFS: How do they work?

ETFs are like a bag into which you can put your choice of simple investments. This ‘bag’ is a company in its own right that is traded on the stock market. Here are a few common questions asked about ETFs:

• Is there a minimum amount to invest? Not really. You only have to buy one share to be involved in the fund, but obviously the shares differ in price.
• Is there a minimum amount of time to invest? No, they’re very flexible. You can leave your investment in for as long or as short a time as you like.
• Are the online brokers discretionary? Online brokers don’t provide advice on what ETFs to buy. This is why their service is cheaper. You read up about funds and just tell them online to go get ’em!
• Do you need any specific information about them before you can invest? You need the code for the ETF that you want to invest in, which can be found on the search function of the broker’s site that you’re using. The main investment companies that offer ETFs are iShares, tracking stock market indices, and Wisdom Tree ETF Securities specialising in commodities ETFs.
• Which online broker should I use?

The most popular online broker platforms include:

• Interactive Investor
• AJ Bell YouInvest
• Hargreaves Lansdown
• IG
• Vanguard

Research all of them before setting up an account. Some charge higher one-off fees while others have a flat-fee that suits high-volume traders (people who make more than a couple of transactions each month).

Check the funds available, too. Interactive Investor, for example, offers a wide range of fund options. Others, like Vanguard, only invest in their own highly-selected funds.

How do I set up my ETF?

First, you’ll need to set up an account with a broker. It’s free to register with them and you don’t have to buy anything immediately once you have your account. You can join now and wait for months before you invest in anything.

To open an account, you’ll need to provide certain information and may need to send proof of identity. You’ll need to show that you’re:

• Over 18
• A UK resident
• A British national

And provide details such as:

• Your address for the last three years
• Your National Insurance number
• Debit card information.

When you’ve registered for an account, it’s easy to look at the ETF information on the site. That’ll help you understand which ones are performing well or have a positive historical performance. Previous performance doesn’t mean it’ll do well in the future – but it can offer a guideline for new investors if the track record shows an overall positive trend.

When you’ve found an ETF – or several – that you’d like to invest in, you’ll need to transfer money to your online account. When you’ve got funds in your account, you can purchase shares in the ETF(s) you’ve had your eye on.

 

Don’t forget to protect it from tax – if you can

You can save a lot of money over time by using ISAs – tax-saving wrappers – to protect your money from tax. ISAs are not products in themselves, they’re like wrappers into which you put an investment and that wrapper stops you having to pay tax on anything you make.

With a Cash ISA, it’s just like setting up a normal savings account with a building society or bank. The difference is when you get your interest, the government won’t take tax out of it.

With a Stocks and Shares ISAs, if your investment grows, you won’t be taxed on that growth. We all have an ISA allowance each tax year (from April 6 to April 5), which is essentially a limit on how much money you can contribute to your ISA in any single tax year.

You can have a Cash ISA and an Equities ISA, but your personal tax-free savings allowance each year is split between them. For the current 2023/24 tax year, the ISA allowance is £20,000.

This means that you could put the full £20,000 into your Stocks and Shares ISA but not put anything into your Cash ISA, or split the allowance between the two.

 

How do I track the progress of my ETF?

You can follow them in the mainstream financial press such as the Financial Times, or you can log into your online broker account to track the live status of your ETFs at any time. Note: Jasmine has invested in a FTSE 100 ETF.

More articles

If you’ve given this a read and want to find out more about investing, then try giving these a read:

• Six investments that aren’t the stock market
• Fund supermarkets: Save money on your investments 
• Self-Select ISAs: Keep your investments in your hands!
• Four common types of investments

 

*This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.

Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.

Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work, and whether you can afford to take the high risk of losing your money.