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Uncovered: How exchange traded funds (ETFs) work

by , 22 August 2013

When it comes to investing in funds, you'll be much better off with ‘passive' funds than ‘active' funds. Exchange traded funds (ETFs) are passive funds. Let's have a closer look at how ETFs work…

Passive funds can work out a better option than active funds, Phil Oakley explains in MoneyWeek.

Passive funds give you the same performance as the market. Active funds try to beat it, but usually fail, partly because their fees are too high.

There are two main types of passive funds. There are index-tracking funds, also known as trackers. And there are ETFs.

Let’s look at how ETFs work…

ETFs use similar tracking methods to tracker funds, from "full replication" to "synthetic". The main difference between ETFs and tracker funds is that ETFs list on the stock exchange.

There are a wide variety of ETFs to choose from

Examples of popular ETFs are:
  • The Satrix 40, which tracks the JSE Top 40 index
  • The db x-trackers FTSE 100, which tracks the FTSE 100 index in London
  • NewGold, which tracks the gold price in rands

Since ETFs list on the stock exchange, you buy and sell them through a stockbroker – just as you would with shares in a company. This means there will be a difference between the buying and the selling price of the ETF – known as the bid offer spread. You will also have to pay commission to your broker.

Check out the costs of buying ETFs before you jump in. It can be quite expensive for making regular – as opposed to lump-sum – investments.

The main reason to buy ETFs: Cheap costs

The point of buying passive funds, like ETFs, is that they are cheaper than actively-managed funds.

The annual fee on an actively-managed fund will usually be upwards of 1.5%.

For a tracker, fees of less than 0.5% are more common.

As a rule of thumb, the more exotic the market, the higher the fee will go.

There you have it, how exchange traded funds work.

Uncovered: How exchange traded funds (ETFs) work
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