What is an ETF? How it works, what it costs, index vs active

An ETF in one paragraph

An exchange-traded fund (ETF) is a fund whose units trade on a stock exchange, so you buy and sell it through a broker the way you would buy a share. One trade can give you a stake in many investments at once, such as shares or bonds. Moneysmart, the consumer website of Australia’s securities regulator ASIC, puts it plainly: “You don’t own the underlying investments directly. Instead, you own a stake in the ETF.”

The value of that stake moves with the assets inside the fund, in both directions. In ASIC’s words: “You can lose money if the value of the underlying assets falls. Fees and trading costs also affect your return.” The ETF provider can create and redeem units as demand changes, which helps keep the market price close to the value of the fund’s assets, its net asset value (NAV).

Index ETFs and active ETFs

• Index (passive) ETFs follow a published index. ASIC notes that in Australia “most ETFs are passive investments that aim to track the value of an index or asset” rather than have a manager choose investments.
• Active ETFs have a manager who picks the investments to reach the fund’s stated goal, which may be to beat an index, to pay income or to grow the fund’s value.

Two more labels are worth looking for. A synthetic ETF copies an index with derivatives instead of owning the assets, and ASIC warns that such funds “have an additional risk that the counterparty to the derivative could fail”. A fund labelled complex may use borrowing, short selling or derivatives. The fund’s official documents (prospectus, key information document or product disclosure statement, depending on the country) state its goal, its method and its costs.

What you pay

1. Expense ratio (also called ongoing charge or management fee): a yearly percentage of your holding. It is taken inside the fund, so you see it as a slightly lower return, not as a bill.
2. Spread: you buy at the higher price and sell at the lower one; the gap is a cost every time you trade.
3. Commission: what the broker charges per order — a fixed amount, a percentage or both.
4. Currency conversion: if the ETF trades in US dollars and your account is funded in naira, pesos or dirhams, the platform converts your money, often with a fee or a margin on the exchange rate — once when you buy and again when you sell and withdraw.

Some platforms also charge a custody fee or an inactivity fee; our guide on choosing an investment platform lists what to check. Separately from fees, ASIC lists currency risk among the risks of ETFs: “overseas investments can be affected by changes in exchange rates”.

Example: one purchase in plain numbers

This is an illustration with made-up round numbers. It is not a forecast and not the price list of any real fund or platform. You convert money to US dollars, buy 1,000 dollars of an index ETF, hold it for one year and sell it at the same price you paid:

• currency conversion when you buy, 1%: 10;
• commission to buy: 2;
• spread, with the buying price 0.10% above the selling price: about 1;
• expense ratio, 0.20% for the year: about 2;
• commission to sell: 2;
• currency conversion back, 1%: 10.

Total: about 27, or 2.7% of the amount, with no change in the ETF’s price. Most of it comes from converting currency, not from the fund’s own fee. Conversion, commission and spread are paid when you trade; the expense ratio is paid every year you hold the fund. So compare the platform’s costs as carefully as the fund’s.

Questions to ask before you buy

• Which index does the ETF follow, or what goal does its manager set?
• Does it hold the assets (physical) or copy them with derivatives (synthetic), and is it labelled complex?
• What is its expense ratio, and what does your platform charge to buy, sell and convert currency?
• In which currency does it trade, and in which currencies are its assets?
• Does it pay out dividends or reinvest them, and in which country is the fund registered? Both affect your tax; see our guide on dividends and withholding tax.