Exchange Traded Funds are a newer form of pooled investment (since 1993 in the USA and 1999 in the UK). To some extent they combine the best features of Investment Trusts and Unit Trusts.
Best to take an example.......
'iShares FTSE 100' is the name of an ETF that tracks the FTSE 100. It is listed in the share pages of the Financial Times under 'Exchange Traded Funds', immediately after 'Investment Companies'. You can also find it on any of the share quote websites under the code ISF. 'iShares' is the brand name of one of the world's earliest and still leading ETF providers originally started by Barclays but now owned by Blackrock.
You can buy and sell an ETF through your broker in exactly the same way as you buy or sell a share or an investment trust.
How does it work?
The manager of ISF holds a basket of shares which mimics the constituents of the FTSE 100, just like any tracker. He collects the dividends on these shares and periodically pays them out to shareholders after deducting his management charges. For ISF these are now (2020) 0.07%.- competitive with other low cost trackers.
The clever twist is what the manager does when shares in the ETF are bought and sold. If buyers and sellers are matched - fine. But if not, (if there is a single big institutional buy order, e.g.) the manager may directly buy the underlying basket of shares in the market (or, more usually, off-market direct from another institution) and issue new ETF shares to the buyers. This process not only ensures liquidity (or at least the same liquidity as the underlying shares), but also means the price of the ETF closely tracks the price of the underlying basket of shares (otherwise an institution could arbitrage the difference).
There are now increasingly sophisticated variants on this basic idea. In one version no actual shares are purchased - the ETF deals entirely in derivatives. It's not clear whether these variants would hold up in the event of a stockmarket meltdown. It's just never been tested.
An ETF marries some of the best features of investment trusts and unit trusts:
- There is a continuous price quotation (unlike unit trusts, where the price is set once per day, which allowed some market timing scams in the US back in 2004).
- There is no discount to worry about (unlike investment trusts).
- There is no stamp duty (although the fund may pay stamp duty on its own share purchases)
- Administration costs are lower than for a unit trust tracker (no monthly statements to you , for example) so charges should be low
- There are no hidden charges.
- You pay broker's commission and the buy/sell spread.
- And because charges should be low does not mean they are. In the US, where ETFs are much more accepted, charges have begun to go up.
Most ETFs are run offshore outside the UK regulatory system. So they are not covered by the UK compensatory regime.
Just because an ETF should be low cost does not mean it is. In the US you can buy Funds of ETFs, with a layer of added costs similar to that for an actively-managed fund thus negating the whole point of an ETF!
There is now a wide range of ETFs covering many specialist areas. This is good, but you have to be careful you are investing in what you expect.
Finally, it must be admitted that they have not yet been battle-tested as widely-used products for the retail investor. Maybe there is a weakness that would be revealed if a sponsor collapses, or if Black Monday repeats, or whatever. So you don't want to put all your eggs in this one basket, and you should avoid versions which do not take actual ownership of the underlying shares.