Everything you need to know about ETFs

How do ETFs work?

ETFs, or exchange-traded funds, are baskets of individual securities, such as stocks, bonds, or commodities, that are bundled into a single fund.

The price of an ETF changes throughout the trading day, reflecting both market demand and the value of its underlying assets. This real-time pricing enables investors to respond quickly to market shifts, offering opportunities for strategic trades and timely portfolio adjustments. Unlike mutual funds, which are priced only once at the end of the trading day, ETFs allow for continuous buying and selling during market hours.

How are ETFs traded?

Exchange-traded funds (ETFs) are purchased and sold exactly like regular stocks on a stock exchange. Just like stocks, the price of an ETF can go up and down and can be traded throughout the day—unlike mutual funds, which only trade at the end of the day for one price.

Another important aspect of trading ETFs is bid-ask spreads. A bid price is the highest price a trader is prepared to pay to open a long (buy) position on an asset. The ask price is the lowest price a trader is prepared to sell an asset for at the current time.

The calculated difference between the bid price and the ask (offer) price is known as the "bid-ask spread." In even simpler terms, it is the difference between the highest price a trader is willing to pay to purchase an ETF and the lowest price a seller is willing to sell the ETF for.

What are the advantages (benefits) of ETFs?

Exchange-traded funds (ETFs) have become a favourite choice for both beginner and more experienced investors because of the many benefits they offer.

Here are our top six:

One of the most significant benefits of ETFs is the ability to achieve instant diversification. Investing in a single ETF exposes you to a broad range of securities across various sectors, geographies, and asset classes. This diversification reduces the risk associated with investing in individual stocks or bonds.

For example, an ETF that tracks the S&P 500 Index provides exposure to 500 large-cap US companies spanning multiple industries. Similarly, international ETFs allow investors to access markets in Europe, Asia, and emerging economies, enhancing the global reach of their portfolios. ETFs typically track an index or sector, also providing diversification across numerous securities.

ETFs often have lower expense ratios and management fees than mutual funds because ETFs usually have a passive management style. Lower fees mean that more of your investment returns stay in your pocket, which can lead to substantial savings and higher net returns.

Accessibility is another advantage. ETFs make it possible to invest in markets or sectors that might otherwise be difficult to access directly. They are easy to buy and sell through brokerage accounts, just like individual stocks. There are no minimum investment requirements beyond the price of a single share, making them suitable for both beginners and experienced investors. Additionally, the wide variety of ETFs available means you can find funds that match specific investment themes or strategies.

Since ETFs trade like stocks, investors can buy and sell them during market hours at market prices. This intraday trading allows investors to react promptly to market events and adjust their portfolios as needed.

Unlike mutual funds, which are priced only at the end of the trading day, ETFs provide real-time pricing and the ability to use various order types, such as limit orders and stop-loss orders. This flexibility can be especially beneficial for active traders or those implementing specific trading strategies.

ETFs generally offer high liquidity, enabling investors to enter and exit positions easily. High liquidity means investors can buy or sell ETF shares without causing significant price changes.

This ease of trading ensures that investors can enter or exit positions quickly and at fair market prices. Liquidity is an important consideration, particularly during volatile market conditions when swift transactions may be necessary.

ETFs typically do not have minimum investment requirements beyond the price of a single share, making them accessible to investors with varying levels of capital. This low barrier to entry allows individuals to start investing with relatively small amounts of money.

Some brokers also offer fractional shares of ETFs, further reducing the minimum investment needed. This accessibility helps investors build diversified portfolios even if they are just starting out or have limited funds.

What are the disadvantages of ETFs?

While there are many advantages to ETFs, there are a few disadvantages you should consider.

ETFs are typically passively managed, meaning they aim to replicate an index rather than outperform it. This limits their ability to adapt to market changes or capitalise on unique opportunities.

Investors seeking alpha may not benefit from the passive nature of most ETFs. When we say "investors seeking alpha," we are referring to investors who want to outperform a market benchmark, such as a stock market index.

While diversification is a benefit, it can also dilute exposure to high-performing stocks. Broad-market ETFs may include underperforming sectors or companies, limiting upside potential.

Concentration risk: Some sector-specific or niche ETFs are heavily weighted in a few companies or industries, exposing investors to heightened risk if those sectors underperform.

Liquidity risk: Niche ETFs focusing on illiquid markets or exotic assets may have low trading volumes, making it harder to buy or sell shares without affecting the price.

ETFs are traded on exchanges like stocks, meaning their prices can fluctuate throughout the day. This intraday volatility can lead to emotional trading and suboptimal investment decisions.

Unlike individual stocks or actively managed funds, ETFs do not allow investors to customise holdings to suit personal preferences, such as excluding specific companies or industries.

What are the risks of ETFs?

While exchange-traded funds (ETFs) offer numerous benefits, it is important to be aware of the risks associated with investing in them and to implement proper risk management strategies. These are the main risks you should be aware of:

ETFs are subject to market risk, meaning their value can fluctuate due to changes in overall market conditions. Since most ETFs aim to replicate the performance of an underlying index or asset class, they are exposed to the same risks that affect those markets.

Factors such as economic indicators, interest rates, geopolitical events, and shifts in investor sentiment can impact the value of ETFs.

For example, if the stock market experiences a downturn, equity ETFs that track stock indices will likely decline in value. Similarly, bond ETFs may be affected by changes in interest rates or credit risks. Being prepared for potential market fluctuations is crucial when investing in ETFs.

ETFs focusing on specific sectors, industries, or themes carry concentration risk. This means they are more vulnerable to events that adversely affect those particular areas. For instance, a technology sector ETF would be heavily impacted by negative developments in the tech industry.

Thematic ETFs, such as those investing in renewable energy or biotechnology, may also face higher volatility due to their narrow focus. If the theme underperforms or loses favour among investors, the ETF’s value could decline substantially. Diversifying investments across different sectors and asset classes can help mitigate concentration risk.

For ETFs that invest in international markets, fluctuations in currency exchange rates can impact returns. If the ETF holds assets denominated in a foreign currency, a stronger domestic currency can reduce the value of these investments when converted back. Currency risk can add volatility to the ETF’s performance, independent of the underlying asset movements.

Changes in laws, regulations, or government policies can impact the markets or sectors in which an ETF invests. Regulatory shifts might affect the ETF’s operations, tax status, or the value of its underlying assets. Staying informed about regulatory developments is essential, especially for ETFs investing in emerging markets or specialised industries.

Why invest in ETFs?

ETFs are a favourite for both beginner and experienced investors. Here are a few reasons why:

• Diversification (spreading out risk). When an investor buys one ETF, they get exposure to a variety of assets, which reduces the risk associated with relying on a single investment.
• Low annual fees. Since ETFs typically have lower costs than actively managed funds, the savings add up, helping investors grow their money faster over time.
• Flexible trading. ETFs trade like stocks, so investors can buy or sell them any time the market is open. This makes them an excellent option for investors who want to react to market changes or have the flexibility to manage their investments as needed.

What is the difference between an ETF and a mutual fund?

When deciding which investment vehicle aligns best with your financial goals, it is crucial to understand the differences between exchange-traded funds (ETFs) and mutual funds.

Both offer diversification by pooling investors' money to purchase a variety of securities, but they differ in several key areas, including costs, trading flexibility, tax efficiency, and transparency.

Cost and expense ratios

One of the primary distinctions between ETFs and mutual funds is in their cost structures.

ETFs generally have lower expense ratios compared to mutual funds, especially actively managed ones. This cost efficiency is largely due to the passive management style of most ETFs, which track an index without the need for active stock selection and frequent trading.

In contrast, mutual funds often involve higher management fees to cover the expenses associated with active portfolio management. Fund managers aim to outperform the market by selecting securities they believe will offer superior returns, which can lead to increased operating costs. Additionally, some mutual funds charge sales loads or commissions when you buy or sell shares, further adding to the overall cost.

For example, an ETF that tracks the S&P 500 Index might have an expense ratio as low as 0.03%, whereas an actively managed mutual fund could have an expense ratio of 1% or more. Over time, these differences in fees can significantly impact investment returns.

Trading flexibility

ETFs offer greater trading flexibility compared to mutual funds. Since ETFs are traded on stock exchanges, investors can buy and sell shares throughout the trading day at market prices.

This intraday trading allows for real-time pricing and the ability to react quickly to market movements. Investors can also employ various order types, such as limit orders or stop-loss orders, and they can purchase ETFs on margin or sell them short.

Mutual funds, however, are priced only once per day after the market closes. All buy and sell orders are executed at the net asset value (NAV) calculated at the end of the trading day.

This means investors cannot take advantage of intraday price fluctuations. Moreover, mutual funds typically do not offer the same variety of order types and often have minimum investment requirements, which can limit accessibility for some investors.

What to look for when choosing an ETF

When deciding which ETFs to choose for your portfolio, your guiding principle should be your financial goals. Articulating your financial goal (i.e., why you want to invest) is important because you also want to ensure that any ETF you choose aligns with your time horizon, whether short-term or long-term.

Also, considering your goal and time horizon will help you determine your risk tolerance. For example, if you are investing for a long-term goal, such as university tuition for your child or saving for retirement, you may have a higher tolerance for risk because the day you need this money is likely far off. However, if you are investing for a short-term goal, such as a holiday or a house deposit, you may have a lower tolerance for risk.

After taking your goals, time horizon, and risk tolerance into consideration, you can start looking for an ETF. There are so many different types of ETFs that it can feel overwhelming, but the advantage is that the variety ensures you will always find an ETF that aligns with your investment profile.

Here are a few things to look for when choosing an ETF:

• Asset class. Check what asset class the ETF holds. The most common ETFs contain stocks or bonds, but others hold currencies, commodities, or alternative asset types. Some ETFs hold a combination of all of these.
• Currency. When choosing an ETF, it is important to be aware of the currency of the underlying assets if it differs from your account’s currency. For example, if you are trading on a EUR account and you buy an ETF tracking a US index, currency fluctuations may impact returns.
• Costs. While generally low, some ETFs have expense ratios that can add up over time. There may also be management fees, so be sure to review the annual costs associated with holding the ETF.
• Holdings. When choosing an ETF, look at the benchmark it tracks, such as an index like the S&P 500, a commodity, or fixed-income securities (such as the Bloomberg U.S. Aggregate Bond Index). Reviewing benchmarks help you assess how the ETF has performed over time and whether it aligns with your risk tolerance.
• Rating.  The rating of an ETF indicates its risk level. Risk is measured on a scale from 1 to 7, with seven being the highest risk.

What is the difference between ETFs, ETCs, and ETNs?

While exchange-traded funds are more well-known, it is also useful to understand the lesser-known but equally noteworthy exchange-traded notes (ETNs) and exchange-traded commodities (ETCs).

So what exactly are they, and how can they help you reach your financial goals?

ETNs are a type of debt security designed to make hard-to-access assets more available to retail investors. ETNs track the total return of an underlying market index or another benchmark. They are usually not backed by collateral because they do not actually hold the underlying asset.

An exchange-traded commodity (ETC) is traded on a stock exchange, just like an ETF or ETN, but it tracks the price of a commodity or the commodity index. This allows investors to gain exposure to commodity markets without buying futures contracts or the actual physical commodity.

The main difference between ETFs and ETCs from a risk categorisation perspective is the number of underlying markets they track. Some brokers offer ETCs that track only a single commodity, such as gold, copper, or crude oil, whereas an ETF tracks a basket of assets. This is why ETFs are often perceived as less risky than ETCs.

What are the different types of ETFs?

Exchange-traded funds (ETFs) come in various forms, each designed to meet specific investment objectives and strategies. Understanding the different types of ETFs can help you choose the ones that align best with your financial goals.

Below, we break down a few of the most common ETF types: equity ETFs, bond ETFs, and commodity ETFs.

Equity ETFs

Equity ETFs invest primarily in stocks that track the performance of a specific stock index or basket of stocks. These ETFs offer exposure to a wide range of companies within a particular market or sector.

Benefits include diversification across multiple companies, access to domestic and international markets, and the potential for capital appreciation and dividend income. Equity ETFs can be categorised into subtypes, such as sector ETFs or thematic ETFs.

Let's take a closer look at two of the most common equity ETFs:

• Sector industry ETFs.  Sector ETFs are made up of stocks from companies focused on specific sectors of the economy, such as technology, healthcare, or energy. They allow you to target industries you believe could outperform the broader market. Common types of sector ETFs include healthcare ETFs, real estate ETFs, energy ETFs, technology ETFs, and utilities ETFs, among others. Benefits of sector ETFs include concentrated exposure to a particular industry, the opportunity to capitalise on sector-specific growth trends, and diversification within a specific sector.
• Thematic ETFs. Thematic ETFs invest based on specific themes or trends, such as renewable energy, artificial intelligence, or cybersecurity. They allow you to focus on emerging areas with high growth potential. Benefits include exposure to innovative and high-growth industries, alignment with personal investment interests, and the potential for significant long-term returns if the theme is successful.

Bond (fixed-income) ETFs

Bond ETFs invest in fixed-income securities, such as government bonds, corporate bonds, and municipal bonds. They are designed to provide regular income and diversify a portfolio with lower volatility compared to equities.

Benefits of bond ETFs include steady income from interest payments, lower risk compared to stock ETFs, and diversification across different types of bonds and issuers.

Commodity ETFs

Commodity ETFs provide exposure to commodities such as gold, oil, and agricultural products without the need to physically own the assets. These ETFs can track the price of a single commodity or a basket of commodities.

Note that in Europe, they are often called exchange-traded commodities (ETCs), and the terms are sometimes used interchangeably.

Benefits of commodity ETFs include diversification beyond traditional asset classes, the ability to hedge against inflation and currency fluctuations, and access to commodity markets without dealing with storage or delivery.

How to invest in ETFs

Investing in ETFs can be a relatively straightforward way to invest, but it involves several necessary steps to ensure your investments align with your financial goals and risk tolerance.

The first step is to select an ETF broker. Brokers provide the platform you will use to buy and sell ETFs, so it is essential to consider factors such as fees, trading tools, and the overall user experience.

Trying a broker’s demo platform is highly recommended before you get started to determine if it is the right fit for you.

Let’s take a closer look at what to consider when choosing your broker:

• Fees and commissions. Look for brokers that offer low commission fees on ETF trades. Be sure to check for any account maintenance fees or additional charges (for example, implied costs from bid-ask spreads) that could reduce your returns over time.
• Trading tools. A broker with robust research tools, real-time data, and educational resources can enhance your investing experience. These tools provide insights into ETF performance and market trends, helping you make informed investment decisions.
• User interface.  An intuitive and user-friendly platform simplifies the trading process. Whether you prefer desktop access or mobile trading apps, ensure the broker’s interface meets your needs.

Comparing different brokers based on these criteria can help you select one that best suits your ETF investing requirements.

Conducting thorough research is essential to selecting ETFs that align with your investment objectives.

Here are some key factors to consider when researching ETFs:

• ETF type and asset class. Based on your investment goals, decide whether you want to invest in equity ETFs, bond ETFs, commodity ETFs, or other types.
• Holdings and diversification. Examine the ETF’s portfolio to understand what assets it holds. Ensure that the level of diversification aligns with your risk tolerance.
• Performance history. Review the ETF’s historical performance, remembering that past performance does not guarantee future results. Look at returns over different time horizons.
• Tracking error. Assess how closely the ETF tracks its underlying index. A smaller tracking error indicates more accurate replication.
• Issuer reputation.  Consider the credibility and stability of the ETF provider. Established issuers may offer more reliable funds.

Understanding the costs associated with ETFs is crucial for maximising your investment returns. Expense ratios and management fees can vary widely among ETFs, impacting your overall gains.

Key cost components:

• Ongoing charges. This annual fee represents the percentage of your investment deducted to cover the fund’s operating expenses. Lower expense ratios are generally more favourable, especially for long-term investments.
• Management fees. Some ETFs charge additional fees for portfolio management services. While most ETFs are passively managed, actively managed ETFs may have higher fees.
• Bid-ask spread. The difference between the buying (ask) and selling (bid) prices can affect your transaction costs. ETFs with higher trading volumes typically have narrower spreads, reducing costs.
• Trading commissions.  Even though many brokers offer commission-free ETF trades, it is important to confirm any potential charges that might apply.

When evaluating costs, compare the expense ratios of similar ETFs tracking the same index. A small difference in fees can add up over time. Also, consider the total ownership cost, including the expense ratio and any trading fees. Lastly, assess whether the ETF’s performance justifies any additional costs, especially for specialised or actively managed funds.

Creating a diversified ETF portfolio involves aligning your investments with your financial goals, time horizon, and risk tolerance.

Steps to build your portfolio:

• Define your investment goals. Clarify whether you aim for capital growth, income generation, or wealth preservation.
• Assess your risk tolerance. Determine how much risk you are willing to take. This influences the types of ETFs you include, such as equities for higher growth potential or bonds for stability.
• Allocate asset classes. Decide on the proportion of different asset classes in your portfolio. A common approach is to diversify across stocks, bonds, and other assets.
• Select ETFs for each category. Choose specific ETFs that fit within each asset class allocation. For example, you might select a broad-market equity ETF, a bond ETF, and a commodity ETF.
• Rebalance periodically.  Regularly review and adjust your portfolio to maintain your desired asset allocation, especially if market movements have shifted the weightings.

Example portfolio strategies:

• Conservative portfolio.  Emphasises stability with a higher allocation to bond ETFs and dividend-paying equity ETFs.
• Balanced portfolio. Combines both growth and income investments, allocating assets between equities and fixed-income ETFs.
• Aggressive portfolio. Focuses on growth with a higher proportion of equity ETFs, including sector-specific or thematic ETFs.

How to invest in ETFs with Saxo

ETFs offer a simple way to gain diversified exposure to a wide range of assets, sectors, or markets—all through a single investment. However, it is important to consider the risks associated with any investment.

Investors who are ready to invest can use Saxo’s platform, which provides everything needed to buy their first ETF. Simply log in, use the ETF screener to find an ETF that fits your investment goals, and enter the ISIN code to make a purchase. Saxo also offers research tools and resources to help you choose the right ETF for your portfolio.

With a Saxo account, you can buy a diverse selection of ETFs, including some of the most popular ones, such as the S&P 500 or Vanguard S&P 500. You can also check which ETFs we offer before opening an account.