ETFs explained: What are they and how do they work?

An exchange-traded fund (ETF) is a type of investment fund that can hold hundreds, sometimes thousands, of investments such as shares or bonds¹.

This is similar to how a mutual fund works. However, there is a key difference: ETFs trade like shares on stock exchanges, such as the London Stock Exchange, meaning you can buy and sell them at any time of the trading day at a known price (we explain how Vanguard trades ETFs later on). Mutual funds², on the other hand, are usually priced once a day.

ETFs are designed to track a particular index, such as the FTSE 100 or Bloomberg Global Aggregate Index³. They offer a simple and low-cost way to hold a broad spread of shares or bonds. Spreading your investments like this helps to reduce your risk compared to owning just a handful of individual shares or bonds.

What’s the difference between an ETF and a mutual fund?

ETFs share many of the same characteristics as mutual funds. They pool investors’ money, which can bring cost benefits. Most are highly regulated, and any investor money is ring-fenced from the fund provider’s own assets.

The main difference is how investors buy and sell ETFs. With mutual funds, the fund provider sets the price and creates or redeems fund units to meet client demand. With ETFs, you can buy and sell them throughout the day on a stock exchange, just like you would with regular company shares.

ETFs have two prices that are shown on the stock exchange: an ask price (the price you buy the ETF for) and a bid price (the price you sell the ETF for). The difference between the two is called the ‘bid-ask spread’.

An ETF’s market price is based on the value of its underlying investments, as well as market supply and demand.

So, which is for you?

Our funds and ETFs tend to track different indices, so your first port of call may be to consider which index you want to invest in. For example, once you’ve decided whether you want to invest in shares or bonds, you might consider if you want to target a specific region or opt for broad global diversification. Read more on what to consider when choosing equity funds and bond funds.

As already mentioned, ETFs are very similar to mutual funds, apart from the way they’re bought and sold. The other factor, and one that may be key in helping you make your decision, is cost.

ETFs are generally cheaper to run than regular funds, which means they can come with a marginally lower ongoing fee (we call this the ongoing charges figure, or OCF for short). However, you might need to pay a stockbroker fee when you buy or sell them as they’re traded on the stock market.

At Vanguard, you can place an ETF trade at no additional cost which we then perform via “bulk dealing” – this is where we combine your trade with that of other investors and place bulk deals twice a day. Your order must be placed before the cut-off times of 10.15am or 2.10pm.

Alternatively, if you would prefer a live price, you can use our Quote & Deal service, charged at £7.50 per transaction. This is to cover our stockbroker costs.

ETFs and mutual funds can help you build a portfolio that is in line with your financial goals. Ultimately, we believe that long-term investing success is built on four simple principles:

• Think about your goals: how much do you need and when for? Are you looking for short-term security (i.e. saving for a house) or long-term gains (i.e. saving for retirement)? This can help when it comes to picking the right investments.

• Stay balanced: invest in the right mix of shares and bonds and ensure it aligns with your goals and attitude to risk.

• Keep costs low: by keeping your costs low, you keep more of your returns. Those savings can really add up, especially in the long term.

• Be disciplined: the most successful investors are often those with discipline and who do not make decisions based on emotions (for example, panic-selling when markets drop).

By focusing on these principles – all areas which you can control – you can put yourself and your investments in the best position to achieve your goals.

¹ Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

² A mutual fund is a shared investment basket where investor funds are pooled together to buy shares, bonds, or a mix of them among other securities.

³ The FTSE 100 Index is the largest 100 listed companies in the UK and the Bloomberg Global Aggregate Index is a flagship measurement of global investment grade debt. Investment grade bonds have a high-quality rating from third-party ratings agencies and are considered to be at a lower risk of default (in other words, the bond is more likely to be repaid at the end of the term).