What are ETFs and how do they work?
Guide Summary
- ETFs are baskets of assets (like stocks, bonds, or commodities) that trade on stock exchanges like individual shares.
- They track specific indices, sectors, or themes, and are usually passively managed to mirror market performance.
- Prices move in real time during market hours, offering transparency, flexibility, and typically lower fees than mutual funds.
How do ETFs work?
ETFs work by tracking a specific index, sector or asset class, and are traded on stock exchanges throughout the trading day — similar to individual shares.
This means that prices fluctuate throughout the trading day, unlike mutual funds which are priced once per day at market close. ETF prices fluctuate during the trading day based on supply and demand, giving investors closer visibility of performance.
Unlike actively managed funds, most ETFs are passively managed — meaning they aim to track the performance of a benchmark or index, rather than trying to outperform it. This usually means lower fund management fees, which can become expensive over the long term.
Types of ETFs explained
There’s a wide range of ETFs available, covering just about every asset type, region, and trend you can think of. Here are some common categories:
- Stock ETFs – Track a group of company shares, often from a major index like the S&P 500 or FTSE 100. They offer broad market exposure in a single investment.
- Bond ETFs – Invest in a mix of government or corporate bonds, offering greater stability and often regular income through interest payments.
- Commodity ETFs – Follow the price of physical goods like gold, oil, or agricultural products, either by holding the actual commodity or companies in the sector.
- Sector/Industry ETFs – Focus on specific areas of the economy, such as healthcare, technology, or finance, allowing you to invest in a theme you believe in.
- Thematic ETFs – Capture emerging trends like clean energy, electric vehicles, AI, or future mobility by investing across sectors aligned to a common theme.
- ESG ETFs – Invest in companies that meet environmental, social, and governance criteria – appealing to values-led investors.
- Crypto or Bitcoin ETFs – Provide exposure to digital assets like Bitcoin or Ethereum, often in a more regulated and accessible form than buying crypto directly.
Why invest in ETFs?
ETFs have become a go-to tool for both new and experienced investors, for several reasons:
- Diversification – One ETF can hold hundreds of underlying investments, spreading risk across sectors, regions, or asset classes.
- Low fees – With most ETFs being passively managed, they typically come with lower annual costs compared to actively managed funds.
- Transparency – ETF holdings are usually published daily, so you can track price movements more closely.
- Accessibility – Traded on major exchanges and available through investment platforms, you can invest in ETFs just like you would a single share.
- Passive investing – For those who want a simple, long-term approach, ETFs allow you to mirror entire markets or sectors without having to pick individual stocks.
How can ETFs make you money?
ETFs can generate returns in two main ways:
- Capital growth – If the price of the ETF rises (because the value of its underlying assets has gone up), you can sell your shares at a profit.
- Dividends – Some ETFs distribute income received from the underlying assets, like dividends from shares or interest from bonds. Others are “accumulating” ETFs, which reinvest earnings automatically to prioritise growth.
How to invest in ETFs (UK)
If you're in the UK and want to start investing in ETFs, here’s how to get started:
- Choose a platform – Use a UK investment platform like Chip.
- Open an account – This could be a Stocks and Shares ISA to benefit from tax-free growth, or a General Investment Account (GIA), where proceeds are potentially taxable, subject to any annual exemption that may apply.
- Find your ETF – Search by index, theme, or region. Many platforms offer filters and performance data to help you compare options.
- Place your order – Decide how much you want to invest and place a buy order. You can invest a lump sum or set up a regular monthly investment.
- Monitor your portfolio – Keep an eye on performance over time, and rebalance your holdings if your goals or risk appetite change.
Risks of investing in ETFs
ETFs offer diversification, but they’re not risk-free. Here are some things to watch out for:
- Market risk – If the assets your ETF tracks fall in value, your investment will too.
- Liquidity risk – Some ETFs (especially niche or new ones) may not be easy to buy or sell at your preferred price.
- Tracking error – Occasionally, an ETF won’t exactly mirror the performance of its underlying index.
ETFs summary
ETFs offer a flexible, low-cost way to invest in a wide range of assets. Whether you’re just getting started or adding diversification to an existing portfolio, they provide instant exposure to markets and themes with relatively low effort.
But like any investment, it's important to research the ETF’s holdings, costs, and strategy before investing.
Our next guide covers commodities, and how physical assets can play a role in a diversified portfolio.
FAQs
What is an ETF in the UK?
An Exchange-Traded Fund (ETF) is an investment fund traded on UK stock exchanges like the London Stock Exchange. It can track markets, sectors, or themes, and is used to build diversified portfolios at low cost.
Does an ETF pay dividends?
Many ETFs pay dividends. Look for “income” or “distribution” ETFs. Some ETFs reinvest the earnings automatically (these are called “accumulating” ETFs).
How do I invest in ETFs?
Open an account with a UK investment platform, choose a suitable ETF, and place a buy order. You can invest via a Stocks and Shares ISA to make it tax-efficient.
How much should a beginner invest in ETFs?
Start with what you’re comfortable with. The emergence of investing platforms means you can now start investing with very little – with Chip, you can get started with £1. The key is consistency and focusing on long-term growth.
What does ETF stand for?
ETF stands for Exchange-Traded Fund – a type of fund you can buy and sell like a stock, offering instant diversification across markets or sectors.
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation. Diversifying means spreading your investments across different sectors, countries and asset classes.
Seccl Custody Limited is the ISA Manager for the Chip Stocks and Shares ISA. A monthly or annual ChipX membership is required for certain funds selected within a Stocks and Shares ISA. Fund management charges apply ISA limits apply.Invest £20k per tax year. Tax treatment depends on individual circumstances and may be subject to change in the future.
GIA proceeds are potentially taxable, subject to any annual exemption that may apply.
Investment into cryptocurrency ETFs is not available via the Chip platform. Chip offers investment funds that invest in different assets as a collective investment.
