Finance can be a mess of an alphabet soup, with acronyms all over the place, so for good measure, let’s add another one to the list – ETF. 

ETF stands for Exchange Traded Fund, which is a relatively new addition to the investment landscape. These types of investment are being talked about increasingly often, and you are likely to have already come across them -- so let’s take a few minutes to examine what all of this is about!

 
Let’s start with the basics: an ETF is a fund that trades on an exchange, like a stock. But instead of representing just one single stock, it holds a basket of securities, usually based on what is called an ‘index’. When we talk about indices, we mean stock ‘lists’, such as the well-known S&P 500, Dow Jones, the Dax and the Eurostoxx 50. The oldest and best-known ETF, for example, is the SPDR S&P 500 – referred to on the exchanges as the SPY. The job of this fund is to track the development of the S&P 500, meaning the largest stocks in the United States. 

An ETF can also be based on just one sector, such as the Technology sector or the Financials sector, or it can even be more country-specific, so one can buy an ETF that invests only in China or Australia. Essentially, the entire investment spectrum is covered by ETFs nowadays; in fact, there are currently over 5000 ETFs being traded around the world. 

So, what are the advantages and disadvantages of an ETF? First and foremost, they provide an easy way to achieve diversification. As we mentioned above, it is like buying a stock, except that when you buy an ETF you don’t just get one stock, you get a whole basket of them, saving you the trouble of buying all these stocks individually. In addition, they tend to have lower fees than traditional funds, which is largely because they only ‘track’ an index rather than try and beat it. 

And this brings us to some of the disadvantages. As ETFs will only aim to replicate an index, investors can be sure that once fees are stripped out, their return will be less than the index. In other words, although they can get easy exposure to the market, they are also sure, from the very beginning, that their return will be less than the overall market they are tracking. At the same time, it is so easy to trade ETFs, as they are on an exchange, that this has led to ‘overtrading’ by retail investors, again causing excess costs and speculation.

In summary, ETFs are a relatively new and innovative addition to the investment landscape and do fulfil a useful role for investors seeking easy diversification. Nevertheless, investors should bear in mind that their return will always be less than the market and should be aware that they should not trade too much, which can prove detrimental to their wealth.