Building Blocks

ETF stands for Exchange Traded Fund, and the name tells you almost everything. It is a fund, a single pooled basket holding many investments at once. And it is exchange traded, meaning that basket is bought and sold on a stock exchange, just like an ordinary share.

So instead of buying one slice of one company, you buy one unit of a fund, and that unit represents a tiny piece of everything the fund holds. Buy one unit of an ETF that tracks the 500 largest American companies, and in that single purchase you own a portion of all 500. One click, the price of one share, and you have the diversification that would otherwise take fifty separate purchases.

Behind every ETF sits a real basket of assets. An ETF tracking the 500 largest US companies actually holds those 500 stocks, in the right proportions, and your unit is a claim on a slice of that real basket. An ETF does not imitate an index; it genuinely owns the holdings.

Most ETFs are built to track an index, a defined list of holdings put together by rules. The fund's only job is to mirror that list: when a company enters the index the fund buys it, when one drops out the fund sells it. No manager forms views on what will do well. This is passive investing in its purest form, the idea from Chapter 1, and it is why ETFs are usually very cheap to own.

Because an ETF trades on an exchange, its price moves through the day as people buy and sell, and stays closely tied to the value of the basket inside. The practical result is what matters to you: you can buy or sell at any moment the market is open, at a known price, as easily as a share. The small cost of running the fund is charged as a yearly fee called the expense ratio, and is usually very low because the fund is passive. We will return to expense ratios when we compare costs across routes.

Index, sector, and thematic ETFs

ETFs differ by what their basket holds, and broadly fall into three kinds, from broadest to narrowest.

• An index ETF is the broadest and most common. It tracks a wide market, say the 500 largest US companies (like the S&P 500) or developed markets worldwide, spreading your money across a large, varied set of companies.
• A sector ETF narrows to a single sector of the economy, holding only technology companies, or only healthcare companies. You would pick one if you had a specific view, but by narrowing the basket you give up some diversification and tie your fortunes to one part of the economy.
• A thematic ETF narrows further, built around an idea across sectors, such as clean energy or artificial intelligence. These target a trend you believe in, but they are the least diversified and often the most volatile.

Physical versus synthetic ETFs

ETFs also differ in how they deliver returns.

• A physical ETF does the straightforward thing: it actually buys and holds the real underlying stocks. What you see is what the fund owns. Most ETFs you will meet are physical, and for a beginner this is the simpler, more transparent kind to prefer.
• A synthetic ETF instead enters a contract with a financial institution that promises to pay it the index's return, without necessarily holding the actual stocks. This introduces a new risk called the counterparty risk: you now rely on the other institution to honour its promise, and if it runs into trouble, the arrangement can get problematic.

Open-ended versus closed-ended ETFs

One structural distinction concerns the supply of units.

• Most ETFs are open-ended: the fund creates new units when demand rises and cancels them when investors exit, so supply adjusts with demand. This keeps the price close to the actual value of the basket. When people speak of ETFs, this is almost always what they mean, and what you will encounter by default.
• A closed-ended fund issues a fixed number of units and does not routinely create more. With supply fixed, the price is set purely by what buyers and sellers will trade at, and can drift above or below the true value of the basket. The takeaway is short: open-ended is the standard, it keeps the price honest, and it is what you will deal with in practice.

Accumulating versus distributing ETFs

An ETF holds many companies, so it collects a steady stream of dividends. What it does with that cash gives us two versions of the same ETF.

A distributing ETF pays those dividends out to you as cash, periodically, to spend or reinvest as you choose. An accumulating ETF instead automatically reinvests them back into the fund, buying more holdings on your behalf. You receive no cash, but the value of your units grows to reflect the reinvested income.

Two reasons this distinction is important.

• Compounding: an accumulating ETF reinvests instantly and automatically, with no gap and no effort, so the money is back at work immediately. Over many years this reinvestment can meaningfully lift your total return versus receiving cash and reinvesting it yourself, which most people do late or imperfectly.
• Cross-border dividends: receiving foreign dividends as cash can involve tax being deducted at the source before the money reaches you, and reinvesting inside the fund can change that picture in the investor's favour. The details will come in Module 3.

• Instant diversification: one unit spreads your money across many companies at once, so no single company can sink you.
• Low cost: most ETFs track an index passively, with no manager to pay, so the yearly expense ratio is usually very low.
• Ease of trading: an ETF buys and sells on an exchange like a share, at a known price, any moment the market is open.
• Transparency: with a physical index ETF, what the fund owns is simply what the index holds, so you always know what you are buying.

• No outperformance: an index ETF is built to match the market, not beat it, so you will never do better than the basket you track.
• Narrower ETFs carry more risk: sector and thematic ETFs give up diversification for a concentrated bet, which can swing sharply.
• Structure matters: synthetic ETFs add counterparty risk, and the wrong share class (distributing when you want compounding) can quietly cost you, so the details are worth checking.
• You do not choose the holdings: you own the whole index as it is, with no say over which companies are in or out.