How do ETFs work?

Exchange Traded Funds enable you to gain diversified exposure to a stock market or sub-sector by investing in just one product.

How do ETFs work? Exchange Traded Funds (ETFs) have revolutionised investing when it comes to getting cost-effective and easily traded exposure to different asset classes or stock markets.
ETFs operate just like old-fashioned mutual funds, with the big difference being that unlike mutual funds, ETFs are listed on the stock market.
This means that whereas traditional funds can only be bought into or cashed out of once a day, you can trade ETFs whenever you like during normal market hours, via your broker, just like with any other share.
And because ETFs are index-tracking funds, there are no expensive fund managers or analysts to pay for.
This makes ETFs much cheaper to run and own then funds run by managers – yet ironically over the medium term index-tracking funds beat most actively managed funds anyway!


Physical and Synthetic ETFs

With just a single ETF purchase, an investor can effectively track the performance of a stock market index of hundreds or even thousands of listed companies.
ETFs also enable you to do the same with indices of government and corporate bonds, with different commodities and currencies – and even with various niche sub-sectors of these different markets.
But how do ETFs do this?
There are two different kinds of ETF:
  • With a physical (or fully replicating) ETF, the ETF provider attempts to track an index by buying the underlying assets of the index with the same weight as in the index, in order to mirror its rise and fall. (If the ETF provider only invests in a selection of the assets, this is called sampling.) 
  • Alternatively the ETF provider may enter a contract with an investment bank to provide the return of a particular index in exchange for a fee. This is called a synthetic (or swap based) ETF.

How physical ETFs work

To construct a physical ETF, the provider purchases all or a selection of relevant securities from within the index to be tracked.

For instance, an ETF designed to track the FTSE 100 index of leading UK shares holds all of the companies in the FTSE 100, in proportion to their weighing in the index.
If HSBC bank made up say 7% of the FTSE 100 index, then the ETF provider seeks to put 7% of its fund's assets into HSBC shares.
As the value of these holdings fluctuate, they track the index's performance.
Note that an ETF's holdings and an index's constituents may not always match precisely. A provider may hold a smaller sub-section (or sample) of the index that it believes can replicate its performance but at a lower total cost.
Replicating an index by sampling is especially used for large indices with hundreds or thousands of stocks, such as the MSCI World index.

How synthetic ETFs work

A synthetic ETF does not directly invest in the index’s constituents.
Instead, the synthetic ETF provider enters into a contractual agreement with an investment bank, with the latter promising to pay the ETF provider the daily return from the index being tracked, plus any dividends due, in return for a fee.
A synthetic ETF can therefore track an index very precisely (before fees) since the investment bank has agreed to pay the exact return to the provider.
Synthetic ETFs can be particularly useful for accurately tracking less liquid markets, where it may not be easy to implement a cost-effective physical ETF. A potential downside is the introduction of so-called counterparty risk, although we do not think this should put you off using synthetic ETFs in most cases. We will explore this in a future article.


Easy to trade

ETF providers work in conjunction with specialist firms known as Authorised Participants or Market Makers to ensure that you can freely trade your chosen ETFs during market hours.
Regardless of whether your ETF is physical or synthetic, you simply buy and sell your desired ETF via your broker.
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