What is an ETF?

An ETF — exchange-traded fund — is an investment fund whose shares trade on a stock exchange like ordinary shares. Most ETFs track an index: an MSCI World ETF holds the roughly 1,400 companies of the MSCI World in the same proportions as the index, so its value moves with the index. A single purchase buys a small slice of all of them.

ETFs have become the most popular building block of private portfolios because they combine broad diversification, low costs and the freedom to buy and sell at any time during trading hours.

How an ETF is priced

The value of one ETF share is the fund's net asset value (NAV) divided by the number of shares:

\text{NAV per share} = \frac{\text{Value of holdings} + \text{Cash} - \text{Liabilities}}{\text{Shares outstanding}}

The exchange price stays close to this value because specialized market participants can create new ETF shares, or redeem existing ones, in exchange for the underlying securities whenever the price drifts away from the NAV.

A simple illustration

An ETF holds securities worth €500 million and has 5 million shares outstanding:

\text{NAV per share} = \frac{500{,}000{,}000}{5{,}000{,}000} = 100

An investor who buys one share for €100 owns one five-millionth of every holding in the fund. If the index rises 1% during the day, the NAV rises to about €101, and the exchange price follows.

What it costs

Running costs: the total expense ratio (TER), deducted from the fund's assets every day. For broad index ETFs it is often between 0.05% and 0.3% a year.
Trading costs: the broker's order fee and the bid-ask spread on the exchange.
Tracking difference: the gap between the ETF's return and its index, which reflects the costs but also securities lending income and tax effects.

ETFs compared with single stocks

Diversification: one ETF can hold hundreds or thousands of companies; a single stock depends on one.
Effort: an ETF adjusts itself to follow its index; a portfolio of individual stocks has to be researched and maintained.
Outcome: an index ETF delivers the market's return minus costs, by design. It will never beat its index, and never fall far behind it.

Types of ETF

Equity, bond, commodity and money market ETFs, by what they hold.
Accumulating or distributing, by whether income is reinvested or paid out.
Physical or synthetic, by whether the fund holds the securities or reproduces the index's return through a swap.
Broad or thematic, from world-wide indices to narrow themes such as robotics or clean energy.

In the EU, ETFs are usually UCITS funds, whose assets are held separately from the provider's own and remain the investors' if the provider fails.

See these numbers for your own portfolio

Floreo works out every figure on this page from your own holdings — returns, risk, allocation, currencies — and the assistant explains them the way this page does. Import from your broker, or try it on the sample portfolio first.

Start Demo

The demo opens straight away on a sample portfolio — no account needed.