How an ETF works
ETFs are a type of fund that you can trade on the stock market. They are pooled investments like investment trusts, OEICs and unit trusts, when you buy a share in an ETF (Exchange Traded Fund) you’re putting your money together with others to invest in the shares of other companies and assets.
ETFs usually invest in a way that tracks the performance of a market index. That could be any index in any type of asset from anywhere in the world.
You can buy and sell ETF shares on the stock market. But in contrast to investment trusts (which are also bought and sold on the stock market) ETFs are ‘open ended’ funds, which means they can issue new shares based on supply and demand.
ETFs have been developed and there are differing innovations such as Physical and Synthetic. Physical replication is where the ETF buys the underlying assets it is designed to track either in full or part. A synthetic ETF is designed to replicate the return of a selected index (e.g. FTSE 100) just like any other ETF. However, instead of holding the underlying securities or assets they mimic the behaviour of the selected index by using derivatives such as swaps.
A total return swap is a financial derivative. In the case of a synthetic ETF, it’s a contract struck with a financial partner (known as a counterparty) to pay the ETF the precise return of its chosen index (both capital gains and dividends) in exchange for a stream of cash.
Please remember the value of your
investments and any income from
them can go down as well as up and
you may get back less than the
amount you originally invested.
All investments carry an element of risk which may differ significantly. If you are unsure as to the suitability of any particular investment or product, you should seek professional financial advice.
Investing in these products may expose you to additional risk, for instance you may be at risk if the product's counterparties fail. It's important you understand the specific risks associated with your investment.
Synthetic ETFs can use derivatives which are used to protect against currencies, credit and interests rates move or for investment purposes. There is therefore a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.
The Financial Services Compensation Scheme does not cover firms based in the Channel Islands, Isle of Man or in Europe, so ETF/ETCs based there cannot benefit from the protection offered by the FSCS if a firm or fund should be unable to pay its liabilities. The Key Investor Information Document (KIID)/Key Information Document (KID) for each fund will specify where it is based.