How exchange-traded funds (ETFs) work

Passive ETFs track a benchmark index such as the FTSE 100 or S&P 500. The performance of the shares and the market capitalisation of the companies within a particular index will be replicated closely by the ETF without the involvement of an active fund manager, keeping costs low.

Smart beta ETFs usually track an index that has been weighted to deliver a specific outcome, such as income or low volatility. Like other ETFs, they are traded like shares on the stock exchange and have the same unique benefits and risks. Because the indices that the smart beta funds track are more complex than for traditional ETFs, the cost tends to be a bit higher than for traditional ETFs.

Different types of smart beta
Whereas traditional indices such as the FTSE 100 are weighted based on the underlying companies market capitalisation, a smart beta index is designed based on other factors:

Minimum volatility smart beta
This ETF attempts to reduce exposure to volatility by tracking indices that aim to provide lower-risk alternatives. For example, a minimum volatility ETF might exhibit less risk during market turbulence compared with a broadly diversified index such as the FTSE All-Share. Some ETFs accomplish this objective by purchasing securities that exhibit relatively low volatility and concentration risk.

Income smart beta
Another factor that smart beta ETFs can be weighted on is income. By screening for stocks that deliver a dividend yield in excess of the market these ETFs can deliver an attractive income for investors. By screening for factors in addition to dividend yield, such as quality, these smart beta ETFs can further narrow down the companies that might be attractive for income investors.

ETFs give you access to a whole world of investment options, covering a broad range of asset classes, sectors and geographies. This can help you to spread risks by avoiding putting all your eggs in one basket.

ETFs often have lower costs than other types of investment funds.

ETFs are traded on stock exchanges, so you can easily buy and sell at any time during the day (provided the market is open).

As ETFs invest in a wide range of asset classes, their value can go up as well as down and you may get back less than you invest.

Even after charges are taken into account, most ETFs will not follow an index perfectly. The gap between performance and the returns from an index is called ‘tracking difference’.