Let's talk about something that's been creating quite a buzz in the investment world for some time now: exchange traded funds. These investments, also known as ETFs, are part of many investor portfolios, from the novice to the seasoned. Though you may have heard the term ETFs before, we're not going to assume you know what they're about.

So, through this article, we aim to help you truly understand how ETFs work. Let's unpack how ETFs work together!

What do ETFs invest in?

An ETF, which (to refresh your memory) stands for exchange traded fund, is like a big basket that holds different types of investments. Buying an ETF lets you invest in this mix all at once, without buying each investment type separately. Let’s check out what could be inside this basket:

Shares

Shares allow you to own a piece of a company. When the company does well, so does your investment. An equity ETF holds many shares from different companies.

Bonds

When you hold bonds, you're lending money to a company or government. In return, they promise to pay you back with a bit extra (known as interest). An ETF can hold many bonds together.

Commodities

This is another way of naming tangible goods like gold, oil, or even wheat. Some ETFs, especially commodity ETFs, let you invest in such goods without having to buy a literal bar of gold or barrels of oil.

Other asset classes

ETFs can also invest in different groups of underlying assets with similar characteristics such as property, currency or infrastructure. For example, an investor might invest in a currency ETF because they believe a particular currency will get stronger compared to others. Or, there are also ETFs (such as thematic ETFs ) that focus on specific industries like tech or health.

Then there are synthetic ETFs, in a league of their own. Instead of directly owning shares or bonds, a synthetic ETF uses various contracts to mimic the performance of a benchmark index or a specific group of assets. So, while a regular ETF holds the actual assets, a synthetic one takes a different route in the hopes of achieving a similar goal.

What are some benefits of ETFs?

With an ETF, you can spread your money across many companies or asset classes. Because of this, diversification is the most ballyhooed potential benefit of investing in an ETF. Diversification theoretically allows you to manage the risk of one (or more) investments performing poorly.

But there are other advantages of investing in an ETF you might want to look into:

Low costs

Often, owning an ETF is cheaper than other investment types. They have what's called an expense ratio – the fee you pay for a professional to manage the investment. However, many ETFs are passively managed and have lower expense ratios. Although a low investment fee is great, fees don't tell the whole story when deciding if an ETF is the right investment for you

Flexibility

You can trade an ETF like you would a regular share. This means you can buy or sell them any time the market's open through your brokerage account.

Earnings

When the underlying assets in an ETF basket perform well, you can receive some of the earnings through a dividend. Some ETFs allow you to adopt a reinvestment plan and use your dividend earnings to buy more ETF shares. Plus, you might also get capital gains if you sell the ETF at a higher price than what you paid for it.

In a nutshell, investing in an exchange-traded fund is a simple way to start your investing journey. ETFs also allow you to start with a small amount and grow from there. With the variety of options, it's more about choosing the right ETF for you

Who decides what the ETFs are invested in?

If an ETF was a ship sailing the ocean of investments, the fund manager would be its captain. Now, why is this captain so vital? Well, they decide where the ship goes. In ETF terms, the fund manager decides where the money (or capital) inside the ETF gets invested. They pick which companies, asset classes, or even countries to include in the ETF basket. They also determine a suitable investment objective for the ETF.

So, you're curious about fund managers looking after your investments? Let's look at some of the well-known managers:

• Vanguard: they're huge in the world of ETFs and mutual funds. One of their top offerings is the Vanguard ETF shares.
• BlackRock: another major player, BlackRock offers iShares ETFs. They have a wide range of options, from the more common equity ETFs to unique commodity ETFs.
• BetaShares: they're a fund manager focused on ETFs and listed funds that appeal to a broad investor base.

How do fund managers decide what to invest in?

A fund manager's approach to deciding what to invest an ETF in depends on whether they're using a passive or active investing strategy. But how does a passive versus an active investing strategy affect the way fund managers manage ETFs?

Passive management

Passive ETFs typically follow a benchmark index, like a list of top companies or a specific sector. The idea is simple: if the index goes up, so should the ETF. If it goes down, the ETF might dip too. The goal? To mimic what the index does, nothing more, nothing less.

Active management

Now, actively managed ETFs don't follow an index. Instead, there's a fund manager actively deciding where the ETF's money goes. They look at factors like market trends, industry buzz, and their personal outlook based on their knowledge and experience. They could invest in shares, maybe some currency assets, or even thematic assets, depending on the goal of the fund.

In short, the fund manager is the brain behind where an ETF's cash gets invested. They're like the captain deciding the ports at which to dock. And while investing always has its waves, having a good captain can make the ride a bit smoother.

How do ETFs interact with the stock market?

You can buy and sell ETFs on stock exchanges like you would with individual shares. If you've ever traded shares, getting ETF shares is a similar game. You simply need a brokerage account to get started. Plus, ETFs can also be traded with other investors, not just directly with the fund. This is known as the "secondary market".

Now, when we talk about ETFs, the main thing to know is passive ETFs are designed to follow a guide or a map. This guide is called a "benchmark index". Think of it like a music playlist. If there's a Top 40 playlist, and you want to listen to all those songs without searching for each one, you'd want a shortcut, right? That's what an ETF does. It gives you a taste of everything on that playlist without you hunting down each song.

So, when we say "ETFs track a benchmark index", it means the ETF tries to match the performance of that index. An ETF is a simple and often cheaper way to get a taste of the whole market or a specific sector.

How do you define ETF success or failure?

In the investing world, ETF performance metrics are like scores and statistics. They help you see how well your investment is doing.

So how can you assess if an ETF is doing well or underperforming?

We've explored in the previous section how many passive ETFs have a goal: they want to follow or "track" the performance of a specific list of shares or assets (benchmark index). This index is like a standard they aim to match or even beat (in the case of an active ETF).

In the ETF world, there's a term called "tracking error". It measures how closely the ETF follows its benchmark index. If the tracking error is high, it means the ETF isn’t keeping up with its benchmark. If it's low, it means the ETF is sticking close to its goal.

Remember to also check the expense ratio when picking an ETF. As mentioned, this is a fee you pay when you invest in the ETF.

Also, let's not forget about dividends. Some ETFs distribute a piece of their earnings, which is like a bonus you get from your investment. When an ETF comes with a regular dividend, it can be seen as performing well. With that said, some high-performing ETFs choose to focus on growth rather than dividends. With this in mind, always be sure to research the specifics of an ETF to ensure its strategy meets your expectations.

How do ETFs compare with other similar investments?

Imagine heading to a store without any idea of what you want. You might end up buying something you don't need, right? Similarly, in the world of investing, there are many types of investments. If you don't compare them, you might end up with something that doesn't suit your needs or goals.

So, with the many investment options available, how do ETFs compare?

Investment type	What's it like?	Unique features to know
ETF (Exchange Traded Fund)	Think of it as a mixtape of investments.	Like stock, you can buy and sell an ETF during the market trading day by using a brokerage account. Many ETFs track a benchmark index, which means they try to mimic the performance of a group of shares or bonds. They also often have lower fees, making ETFs cheaper to hold.
Stocks (a.k.a. shares)	Direct ownership in a company.	The value of your investment is directly tied to company's performance. You can earn dividends or even sell your share for more than you bought it (hello, capital gains). However, no diversification means a higher risk, as you're banking on one company performing well.
Mutal Funds	Imagine everyone's money in one big pot.	Professionals manage this pot, picking and choosing where the money goes. Because of this, you might see higher fees. Also, you buy mutual fund shares at the end of the trading day, not throughout. Investing in a mutual fund also requires a higher minimum investment.
Managed Funds	Like mutual funds, but with extra attention.	Managed funds are actively managed, meaning the fund manager is looking to beat the market. This special attention can mean higher fees but also the potential for higher returns. Like mutual funds, they can only be bought and sold at the end of the trading day.
Index Funds	Like an ETF but can only be bought and sold when the market closes.	Index funds follow a specific set of companies (an index). Because they're passive and not trying to outdo the market, the fees are often lower as there's less decision-making involved. Like mutual funds and managed funds, index funds can only be bought and sold at the end of the trading day.

ETFs, shares, and the different types of funds have their own perks. The question is: which one is the best for you? It's important to take your time to research and understand the different types of investments to see what feels right based on your circumstances and preferences.

How do ETFs work — key takeaways

So, we've seen that ETFs have become pretty popular lately. They’re a hit, as they give us a chance to invest in many things like stocks, bonds, or even commodities without having to pick each one by ourselves. It's like having a sample of everything without taking too much at once.

Who decides what goes into an ETF? That's up to the fund managers. Some stick to a set list, like tracking an index – that's passive. Others, looking at what's going on in the market might make different choices – that's active.

But remember, not everything goes as planned. In the world of ETFs, success is about how closely they follow their chosen path or index. If they stray from it, known as a tracking error, they might not be doing their best.

ETFs have many investment relatives like mutual funds, managed funds, index funds and stocks. But ETFs often come with a more approachable price and flexibility that many new investors appreciate.

So, if you're thinking about investing in ETFs, now you understand how they work. Remember, every investment has its moments, so stay informed, ask around, and enjoy the journey.