What are ETFs? Explained simply

If you’re interested in investing in ETFs, but want to understand what you’re getting into before starting to invest, you’ve come to the right place. In this blog, we’ll explain ETFs in simple terms and help you understand what all the fuss is about, including associated advantages and disadvantages.

There are so many investing options out there, it can be difficult to understand which investing approach works for you. Read on for an explanation about the differences between ETF investing and other popular investing vehicles to help you paint a picture of how ETFs fit into the investing landscape.

ETFs are a way to invest money. The goal of investing is to put money into something that gains value over time. Investors' money is spread across various assets to create a collection of stocks and bonds from different companies.

This spread follows an index—a type of list of companies or other assets (such as commodities). An index could include, for example, the 25% most sustainable publicly listed U.S. companies. As the value of the companies represented in the index fluctuates, so does the value of the investment.

ETF meaning

This acronym stands for "Exchange Traded Funds," which are funds designed to passively track the performance of a specific index, as opposed to a fund that is actively managed. Investing in ETFs means that a single investment allows you to invest in a variety of companies or assets.

What does it mean to be exchange-traded? What makes something a fund? And what is an index?

Exchange-traded: This term means that something is traded on the stock exchange, making this investment type especially flexible. Investors can buy or sell their investments as long as the stock exchange remains open.

Fund: Essentially, a fund pools capital from many investors and distributes it across various assets. With an ETF, this distribution usually follows an index (an index fund). In contrast, actively managed funds have their composition managed manually.

Index: An index is a benchmark representing the value of a group of assets. For example, some indices track the 50 largest companies in a country or the most sustainable companies in a particular industry. The index's value rises and falls with these companies' (or assets') values.

How do ETFs work?

ETFs are put together by a sponsor who decides which index or group of assets the fund will track. The sponsor then works with large institutional investors, called authorised participants, to assemble the actual stocks or bonds in the right proportions. These assets are bundled into the ETF, and shares are created and sold on the stock exchange, where anyone can buy or sell them during market hours.

Most ETFs weight the companies they hold by market capitalization, meaning bigger companies make up a larger share of the fund and have more influence on its performance. For example, in a market-cap-weighted ETF, a company like Apple would have a much higher weight than a smaller company. Some ETFs use other methods, such as giving each company an equal weight regardless of size, or weighting based on financial factors like sales or dividends. This weighting method is chosen when the ETF is created and determines how much each company affects the ETF’s overall value.

Why are ETFs so popular?

The popularity of ETFs has grown rapidly in recent years, and for good reason. ETFs are low-barrier, easy to manage and aim to reduce risk through diversification. Here are a few of their biggest selling points:

• Unlike many other investments (such as real estate) there’s no minimum investment when investing in an ETF. In fact, you can start investing in ETFs or ETF portfolios with as little as one euro.
• There’s something for everyone, depending on one’s individual tolerance (or appetite) for risk. ETFs allow investors to participate in the developments of entire markets or countries, which helps diversify risk. 
• As a type of passive investing, ETF investing also represents a lower time commitment as compared to active investing. At Peaks we reduce the time needed even more with automated deposits and pre-built ETF portfolios, which enable you to choose a risk profile without the need to wade through the ETF market yourself.
• ETFs are known for their high liquidity, meaning they can be easily bought or sold during stock exchange trading hours. This flexibility makes ETFs more accessible compared to some other investment types that have restrictions on when transactions can be made.
• ETFs are regulated investment products, and their oversight helps ensure transparency and investor protection. Regulations typically require ETF providers to disclose detailed information about their holdings, fees, and performance. This transparency makes it easier for investors to make informed decisions. Additionally, ETFs must comply with strict rules regarding how closely they track their underlying indices.

Different types of ETFs

The Peaks app offers readymade portfolios of ETFs, assembled based on industry knowledge of the following types of ETFs. As you can imagine, each type of ETF serves a different purpose and suits different investing goals. For example, thematic ETFs allow you to align investments with your personal interests, while index ETFs are a simple way to match market performance. Knowing these categories can help you pick ETFs that align with your financial goals and risk tolerance.

Thematic ETFs focus on specific trends or themes that investors believe will grow over time, such as clean energy, artificial intelligence, or innovative healthcare. They invest in companies related to that theme, making them a good choice for those wanting to align their investments with emerging trends or personal interests.

Commodity ETFs invest in raw materials like gold, oil, or agricultural products. They either track the price of these commodities or invest in futures contracts tied to them. These are often chosen to build in a buffer against inflation, or to diversify a portfolio with non-stock assets. They are also known as exchange-traded commodities (ETCs)

Index ETFs aim to replicate the performance of a specific market index, such as the S&P 500 or MSCI World Index. They hold a portfolio of stocks or assets that match the index, making them a way to achieve broad market exposure.

Regional ETFs focus on stocks or assets within a particular geographic area, like Europe, Asia-Pacific, or North America. These ETFs allow investors to diversify globally while concentrating on regions with strong economic growth potential.

Country-specific ETFs invest in assets from a single country, such as the U.S., China, or Germany. These ETFs are ideal for those looking to focus on countries with strong economies or growth opportunities.

Sector ETFs target specific industries or sectors of the economy, such as technology, real estate, healthcare, or energy. They invest in companies within those industries, making them a good choice for investors looking to capitalise on the growth of particular sectors.

Do Bitcoin ETFs exist?

Bitcoin ETFs are just one of many asset options for a diversified portfolio. Although, ‘Bitcoin ETF’ is actually not the correct term, at least in terms of what Peaks offers. ‘Bitcoin ETP’ which stands for ‘Exchange Traded Product’ is more accurate. They serve as an interesting example because of their volatility level, which contrasts starkly with that of most ETFs.

This product tracks the price development of Bitcoin (instead of an index), one of the most well-known cryptocurrencies. While you don’t buy Bitcoin directly when buying this ETP, you are still participating in its performance.

Good to know: Due to the high price volatility of cryptocurrencies, this type of investment has especially high volatility. Including crypto ETPs in a portfolio can help diversify your risk. It may be worthwhile to invest in cryptocurrencies long-term, depending on your situation and priorities.

Which ETFs are best to invest in?

As an execution-only investment firm, Peaks doesn’t provide personal investment advice or recommend specific ETFs. However, we can share objective information about some of the most popular ETFs and the criteria we use to assemble our readymade ETF portfolios.

Peaks portfolios are built with diversification, sustainability, and cost-efficiency in mind. We select ETFs that align with different risk levels, ensuring a balanced mix of equities and bonds. Additionally, we prioritise ETFs with strong ESG ratings (A or higher, as rated by MSCI) and low expense ratios to help investors manage costs while growing their wealth over time. 

While we can’t advise on which ETFs to choose, we encourage first-time investors to get a taste for investing using our readymade portfolios which were built with the utmost care and expertise! For those interested in building their own portfolio, you can create a custom portfolio in the Peaks app too.

Some ETFs on offer at Peaks include the iShares AEX UCITS ETF, which provide broad market exposure. For those focused on sustainability, ETFs like the iShares MSCI Europe SRI ETF track indices with strong ESG criteria.

The difference between ETFs and index funds

ETFs and index funds share a common goal: tracking a specific market index to provide diversified, passive investing. However, they differ in how they are bought and sold.

ETFs trade on stock exchanges like individual stocks, meaning investors can buy or sell them throughout the trading day at market prices. In contrast, index funds can only be bought or sold at the end of the trading day at their net asset value (NAV). This makes ETFs more accessible for investors who prefer real-time pricing.

ETFs and sustainability

Sustainable ETFs track indices that prioritise companies with strong sustainability practices, such as reducing carbon emissions, promoting diversity, or adhering to ethical labor standards. The sustainability of an ETF is measured through ESG ratings, provided by independent agencies like MSCI, which assess how well the companies within the ETF perform on certain environmental, social, and governance (ESG) criteria.

These ratings take into account factors like a company’s carbon footprint, resource usage, treatment of employees, and governance practices. By choosing sustainable ETFs, you can support long-term economic and environmental stability while aligning your portfolio with values-driven investing. Some people also believe that going the sustainable route with ETF investing is a general best practice, as this automatically weeds out controversial companies and sectors that tend to display higher volatility.

ETFs in Peaks portfolios are exclusively given a rating of A or higher on the ESG rating scale by the independent rating agency MSCI.

How safe are ETFs?

As you can see, there are quite a few factors to consider when choosing how and in what to invest. How much are you willing to invest and how much effort you’re willing to dedicate to managing it are two important considerations. Perhaps the most important one of all, however, is how high the risk is of losing your invested money. 

Investing always carries risks, and ETFs are no exception. Here are some facts about risk:

• "Volatility" describes the price fluctuations of an ETF. The higher the volatility, the greater the risk.
• The risk of ETFs is closely tied to their potential returns. Generally speaking, the more an ETF fluctuates in value, the higher their potential gains and losses.
• With ETFs, you’re typically investing in a group of companies, countries, or other assets. Gains or losses in one asset can be offset by gains or losses in another—a concept known as risk diversification.
• For even more diversification, you can invest in an ETF portfolio, which contains multiple ETFs. This spreads the risk further by including more sectors or global regions in one investment portfolio.
• Long-term investment is another essential factor. Based on historical performance, ETFs are expected to increase in value over the long term. Short-term market fluctuations are thus able to balance out over time. 
• You should only invest money you can afford to set aside. This way, you’ll never be forced to sell your investments quickly when their value is low.
• There are many different types of ETFs, each with a corresponding risk level. It’s important not to treat all ETFs as one and the same.
• Not all ETFs are regulated equally—particularly those traded internationally or focused on emerging markets—so it’s important to verify the regulatory framework of the ETF you’re considering.

What does it cost to invest in ETFs?

When investing in ETFs, there are typically three types of costs to be aware of: provider fees, fund costs, and spread.

Provider fees: These are the fees charged by the platform or app you use to invest in ETFs, like Peaks or another investment app or brokerage platform. They cover the cost of accessing the ETF marketplace and using the provider's tools and services.

Fund costs: Fund costs, also called expense ratios, are fees charged by the ETF itself for managing and operating the fund. These fees are typically expressed as an annual percentage of the fund’s assets (e.g., 0.10%). They go to the fund managers to cover administrative costs, index tracking, and other operational expenses. Fund costs are deducted directly from the fund’s returns, so you don’t pay them out of pocket but may notice their impact on your overall performance.

Spread: The spread refers to the difference between the price at which a market maker is willing to sell an ETF (the "ask" price) and the price at which they are willing to buy it (the "bid" price). It represents the cost of trading an ETF and is influenced by factors such as the ETF's liquidity and the volatility of its underlying assets. A narrower spread means lower trading costs, while a wider spread can make the trade more expensive.

Tax implications of investing in ETFs

When investing in ETFs, it’s important to understand the tax implications. Depending on where you live, you may be subject to capital gains tax when you sell an ETF at a profit, or taxes on dividends paid by the ETF. In some cases, reinvested dividends may also be taxable. 

You can read more about your country’s approach to taxing investments on your government’s tax administration website. Residents of the Netherlands can find this information in English in the Belastingdienst Box 3 environment.

We recommend that you consult a tax advisor to understand how investing in ETFs fits into your overall tax situation.

Is investing in ETFs something for you?

In short, ETFs offer a simple and flexible way to build wealth over the long term. Due to their versatility, they’re suitable for both beginners and experienced investors. They also offer a range of options for different risk tolerances.

At Peaks you can also choose to invest a set amount daily, weekly, or monthly. Once you’ve set up your investing deposits, you can choose to have them repeat automatically. You can adjust or stop these deposits whenever you like, since we believe investing should adapt to your life—not the other way around.

Having said this, it’s always important to note that with investing there’s always a risk of partially or fully losing your investment.