In the fast-paced world of investing, exchange-traded funds (ETFs) have become a go-to for both beginners and seasoned investors. But what exactly are ETFs, and how do they work? 

Let’s break it down and explore why they may be a valuable addition to your portfolio.

An ETF is a pooled investment that tracks the performance of a specific index, sector, commodity, or asset, and can be traded on a stock exchange like a stock. ETFs may hold a variety of investments, including stocks, bonds, commodities, or a combination of these.

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How ETFs work

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Creation and redemption: Large financial institutions called authorised participants (APs) create or redeem ETF shares in large blocks, ensuring price stability.

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Index tracking: Most ETFs follow a specific index (e.g., FTSE 100), allowing investors to gain exposure to an entire market or sector.

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Traded on exchanges: Unlike mutual funds, ETFs can be bought and sold throughout the trading day, offering greater flexibility.

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Market price vs. NAV: ETFs have a market price and a net asset value (NAV), which reflects the underlying assets. Due to the creation/redemption mechanism, the two are typically closely aligned.

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The pros of ETFs

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• Diversification: ETFs provide easy access to a wide range of securities in one trade.
• Low costs: They generally have lower fees compared to actively managed funds.
• Flexibility: You can trade ETFs throughout the day, giving you the agility of stocks.
• Transparency: Most ETFs disclose their holdings daily, providing insight into where your money is invested.
• Tax efficiency: ETFs tend to be more tax-efficient than mutual funds, generating fewer capital gains, however if the fund is held within an ISA wrapper you're shielding from income and capital gains tax.
• Accessibility: They offer access to different markets and asset classes, from equities to bonds, commodities, and niche markets.

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The cons of ETFs

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• Trading costs: Frequent trading can rack up brokerage fees, diminishing returns.
• Tracking error: Some ETFs might not perfectly follow their underlying index.
• Liquidity: Niche ETFs may have lower trading volumes, which could impact buy/sell prices.
• Complexity: Leveraged or inverse ETFs are complex and can be riskier than standard funds.

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How to start investing in ETFs

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Investing in ETFs can help you build a diverse portfolio managed by experts. Here's what investing in ETFs with Chip looks like:

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Explore themed funds: Choose from a range of ETFs that align with your interests, such as Clean Energy, Healthcare Innovation, or Crypto Companies. These funds are professionally managed by leading asset managers.

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Low-cost investment: ETFs provide a cost-effective way to diversify your portfolio without having to buy individual stocks or bonds, making them accessible to all types of investors.

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Diversification: ETFs contain a broad mix of assets, helping you spread risk by not relying solely on a few stocks.

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Professional management: Let the world’s top asset managers handle your investments, so you can sit back and watch your portfolio grow.

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ETFs offer a flexible, low-cost way to build a diversified portfolio, blending the benefits of mutual funds with the agility of stocks. Their accessibility, tax efficiency, and transparency make them appealing to many investors. However, it’s important to understand the underlying assets, expenses, and risks associated with each ETF.

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As always, it’s wise to consult with a financial advisor to see if ETFs align with your financial goals. However, when used correctly, ETFs can be a powerful tool in building long-term wealth.

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Please note: Chip does not offer financial or tax advice, and this should not be considered personal financial advice.The value of your investments can go down as well as up and you may get back less than your original investment

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Chip Financial (Investments) Ltd is authorised and regulated by the Financial Conduct Authority, under firm reference number 1005114.

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Seccl Custody Limited is the ISA Manager for the Chip Stocks and Shares ISA. A monthly or annual ChipX membership is required and fund management charges apply. ISA limits apply. Invest £20k per tax year. Chip does not provide tax advice or financial advice. Tax treatment depends on individual circumstances and may be subject to change in the future.

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