What are ETFs and how do they work?

Exchange traded funds, or ETFs, are a popular way to invest worldwide. These funds are traded on the stock exchange and offer a flexible, cost-effective way to invest in a wide range of asset classes, including indices, shares and commodities.

But how exactly do ETFs work, and what makes them such an attractive option for investors? In this article, we’ll break down what ETFs are. After a clear definition, we’ll explain how ETFs differ from traditional investment funds. You’ll also learn about the benefits and potential risks, where and how to buy ETFs, and what costs to expect.

• Definition: ETFs (exchange traded funds) are investment funds that are traded on the stock exchange. They aim to replicate the performance of a specific index, offering a low-cost and diversified way to invest across different markets.

• Advantages: Diversification, cost‑effectiveness, transparency and flexibility make ETFs a popular choice for investors, especially beginners.

• Risks: Before investing, it’s important to understand the risks. These include market fluctuations, liquidity challenges, currency risk and potential risk linked to the issuer of the ETF.

• Investing: To invest in ETFs, you first need to open an account with a broker, deposit funds and select the ETF that matches your goals.

Explanation: What are ETFs?

Simply put, ETFs are funds that mirror the performance of a specific index. A fund is an investment model where money from many investors is pooled together and invested across a range of securities, such as shares, bonds or property. A fund company or professional fund manager oversees this capital and manages the investments according to a set strategy.

An ETF holds a basket of securities that usually track the performance of an index like the DAX, S&P 500 or MSCI World. These index funds allow investors to buy into a broad mix of stocks, bonds or other asset classes with a single transaction. This gives investors access to a diversified and professionally managed portfolio, helping to spread risk and open up opportunities in multiple markets and asset types.

There are different types of funds including equity funds, bond funds, mixed funds and index funds, each with its own goals and investment approach. ETFs are especially flexible because they’re traded on stock exchanges just like individual shares. You can buy and sell them at any time during trading hours, which makes them highly liquid. On top of that, ETFs tend to be more cost-efficient than traditional mutual funds, as they are usually passively managed and involve lower management fees.

What is the difference between ETFs and mutual funds?

The main difference between ETFs and traditional investment funds lies in how they’re traded. ETFs are listed on the stock exchange and can be bought or sold throughout the trading day, reflecting real-time market prices. In contrast, investment funds are only priced once per day and can only be purchased or sold through the fund provider at the official redemption price.

Index funds, a subset of investment funds, have a lot in common with ETFs. Both aim to replicate the performance of a specific index, investing in the same securities that make up the index. They offer a low-cost way to diversify across an entire market or market segment. The key distinction lies in how they’re managed and traded.

Unlike actively managed funds, where a fund manager attempts to outperform the market by selecting specific securities, index funds are passively managed and aim to match the index’s performance.

Management and costs

• ETFs: These are usually passively managed. Because they track an index rather than trying to beat it, management fees tend to be lower.

• Mutual funds: These may be actively managed, with a fund manager making decisions to try and outperform the market. This active approach typically results in higher fees.

Trading and flexibility

• ETFs: Since ETFs are exchange‑traded funds, investors can trade them like shares on the stock exchange, which allows flexible buying and selling during trading hours.

• Mutual funds: These are priced once a day after markets close. You can only buy or sell them at the daily redemption price.

Investment strategy

• ETFs: These are ideal for investors who prefer a passive, cost-effective approach and want broad diversification by tracking a market index over the long term.

• Mutual funds: These may appeal to investors who value active management, where a fund manager selects specific securities, for example through stock picking, in an effort to achieve higher returns.

What types of ETFs are there?

There are several types of ETFs that cover different asset classes, strategies and income uses. Depending on your investment goals it’s sensible to know the different types of ETFs before you invest your money.

ETFs by asset classes

• Equity ETFs: replicate equity indices such as the S&P 500 or DAX

• Bond ETFs: invest in various bonds such as government or corporate bonds

• Commodity ETFs: cover commodities such as gold, silver or oil

• Dividend ETFs: focus on shares with high dividend yields

• Real‑estate ETFs: invest in real estate via real‑estate funds for example

• Money‑market ETFs: cover short‑term, safe money‑market instruments such as overnight deposits, short‑term government bonds or fixed‑interest securities

• Multi‑asset ETFs: mix different asset classes, offer more diversification and spread risk

• Crypto ETFs: invest in cryptocurrencies such as Bitcoin or Ethereum

ETFs by investment strategy

• Sector ETFs: focus on specific sectors such as technology, healthcare or energy

• Regional ETFs: invest in specific geographic regions such as Europe, Asia or emerging markets

• Thematic ETFs: focus on special themes such as renewable energy or artificial intelligence

• Smart‑beta ETFs: use advantages from both passive and active investing and have a clear strategy where the broad market serves as a basis and companies are selected according to certain factors

ETFs by income use

• Accumulating ETFs: the return is automatically reinvested and used for compound interest effect

• Distributing ETFs: the return is paid out to the investor

Buying ETFs: how it’s done

Purchasing ETFs is a straightforward way to invest diversely in different markets. What are the steps to buy ETFs? With the following explanation you can successfully buy exchange traded funds.

1. Open an account: Choose a broker or a trading platform like Bitpanda and open your account.

2. Deposit money: Deposit funds into your account so you can purchase ETFs.

3. Search for an ETF: Use the search function on Bitpanda or your broker to find the desired exchange traded fund.

4. Check information: Research the composition and performance of the ETF to ensure it fits your investment goals.

5. Place purchase order: Enter the number of shares you want and place the purchase order.

6. Set up savings plan (optional): A savings plan for ETFs is important if you’d like to invest regularly in ETFs.

7. Review portfolio: Check your portfolio regularly and adjust it if necessary.

Use the Bitpanda platform for an easy entry into the world of ETFs. In addition to well‑known indices like the S&P 500, MDAX or MSCI World you’ll also have access to exchange‑traded commodities and shares and fractional shares so you can build your portfolio flexibly across various asset classes from ETFs to commodities to stocks.

Where can you buy ETFs?

Exchange traded funds are bought and sold on the stock exchange, just like individual shares. This means you can usually trade ETFs wherever you’d trade shares – through online brokers, direct banks or digital trading platforms. These providers typically offer access to a wide selection of ETFs and make investing straightforward and flexible.

To get started, you’ll need to open and verify an account with your chosen provider. Once your funds are deposited, you can use the search function to find and invest in the ETF that fits your goals. When choosing a provider, look for low trading premiums and a user-friendly platform  like Bitpanda.

ETF cost breakdown

In short, ETF costs include the total expense ratio (TER), trading premiums and any applicable spreads. Depending on your broker, there may also be custody fees and taxes on capital gains. Compared to actively managed investment funds, ETFs are usually cheaper, as they’re typically passively managed and involve less administration.

A breakdown of typical ETF costs

• Total expense ratio (TER): This covers the ongoing costs of running the ETF including management, marketing and operational expenses. The TER is deducted automatically from the fund and usually ranges between 0.05% and 0.5% per year.

• Trading premiums: These are the fees you pay when buying or selling ETFs. The exact amount depends on the broker or platform you use.

• Spreads: The spread is the difference between the buying and selling price of an ETF. A wider spread can lead to slightly higher costs when trading.

• Custody fees: Some brokers charge an annual fee for holding your securities. However, many online brokers have removed these fees entirely.

• Taxes: Any profits from ETFs – such as capital gains or dividends – are subject to capital gains tax, depending on the tax regulations in your country.

What should you consider when investing in ETFs?

Finding the right ETF starts with understanding your investment goals and risk tolerance. You’ll also want to compare different ETFs based on how they track their index, their costs and past performance. Another important decision is choosing between accumulating and distributing ETFs, depending on your investment strategy.

What to consider when selecting an ETF

• Investment goals and strategy: Before picking an ETF, define your long-term goals. Are you focusing on equities, bonds or other asset classes? Your choice should align with your broader investment plan.

• Risk tolerance: If you're looking to spread risk, consider ETFs that track a broad index with many securities. The more diversified the ETF, the lower the risk from individual market fluctuations.

• Fund volume: A larger fund volume often indicates strong market presence and higher liquidity – which can make buying and selling easier.

• Historical performance: Look at how the ETF has performed over time. While past performance doesn’t guarantee future results, it helps to assess how closely the ETF has followed its index, especially when checking for tracking error.

• Distribution type: Choose between an accumulating ETF, where profits are automatically reinvested, or a distributing ETF, where profits are regularly paid out to your account. The best option depends on your income needs and reinvestment strategy.

To learn exactly how to invest in ETFs, check out our guide in the Bitpanda Academy.

What are the advantages and disadvantages of ETFs?

Like any investment, ETFs come with both benefits and risks. It’s important to weigh these carefully before deciding whether an exchange traded fund suits your investment goals. While ETFs offer low costs, transparency and broad diversification, they also involve risks like market volatility, liquidity issues and concentration in certain sectors.

Here’s a clear overview to help you decide:

Advantages of ETFs

• Diversification: ETFs track indices made up of multiple securities. This spreads your risk more effectively than investing in individual assets.

• Low costs: Because ETFs are usually passively managed, they come with lower ongoing charges and no entry fees compared to actively managed funds.

• Transparency: Most ETFs disclose their holdings daily, so you always know what you’re investing in.

• Flexibility: ETFs are traded during exchange hours, meaning you can buy and sell them throughout the day – not just once, like traditional funds.

• Accessibility: You can start investing in ETFs with relatively small amounts, making them suitable even for beginners.

Disadvantages of ETFs

• Market fluctuations: ETF prices move with the market. This can lead to losses, especially in the short term. ETFs are better suited to long-term investing and building wealth over time.

• Liquidity risk: In some cases, there may be delays or issues with processing ETF sales – especially during volatile market periods.

• Concentration risk: ETFs that focus on a single sector or region may be more vulnerable. If one major company underperforms, it can significantly affect the whole fund.

• No chance of outperformance: Since ETFs passively follow an index, they’re designed to match market performance – not beat it. This means they can’t deliver returns above the index they track.

Frequently asked questions about ETFs

Why are ETFs so popular with beginners?

ETFs are especially popular with beginners because they’re easy to understand, affordable and well diversified. They track the performance of an index, allowing investment in many different shares or other asset classes with just one product. This means risk can often be spread more broadly than with individual stocks. At the same time, time-consuming decisions such as selecting specific stocks are avoided. ETFs are generally cheaper than actively managed funds and accessible with small amounts, e.g. via a savings plan.

How do ETFs generate returns for investors?

ETFs can generate returns in two ways. First, through capital appreciation or so-called price gains, when the value of the securities contained in the ETF rises over time. This happens, for example, when the stocks in the tracked index gain value.

Second, some ETFs generate regular income through dividends when companies in the fund pay out profits. These dividend payments are distributed to investors in distributing ETFs, while in accumulating ETFs they are automatically reinvested, helping to build wealth.

What is the best ETF?

There’s no such thing as the best ETF, as the choice depends on individual investment goals, risk tolerance and the desired market. Popular ETFs are those that track large, diversified indices like the MSCI World or the S&P 500, as they offer broad diversification. Which ETF suits you depends on whether you prefer to invest in shares, bonds, commodities or a mix of asset classes. Comparing costs, index tracking, income use and fund size can help with your decision.

More topics around investing

Want to deepen your knowledge about ETFs, savings plans, investments and the financial world? Then take a look at more articles in our Bitpanda Academy. You’ll also find exciting lessons on topics like stocks vs. ETFs, commodities, crypto trading, blockchain technology or Bitcoin mining.

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