The mechanism that makes it work
An ordinary fund prices once a day and deals directly with you. An ETF instead lists on an exchange and relies on a creation and redemption mechanism: authorised participants — large market-making firms — can hand the fund a basket of the underlying securities in exchange for new ETF shares, or hand back ETF shares to receive the securities.
That arbitrage is what keeps the ETF's market price tethered to the value of what it holds. If the ETF trades above its net asset value, an AP creates new shares and sells them; below, they buy and redeem. It usually works to within a few basis points, and it works least well exactly when markets are stressed and the underlying is hardest to trade.
Physical versus synthetic
A physical ETF actually owns the shares or bonds in the index. A synthetic ETF owns something else and enters a swap with a bank that pays it the index return. Synthetics can track difficult markets more precisely and sometimes more cheaply, at the cost of counterparty exposure to the swap provider. For most purposes, physical replication is the more straightforward thing to own.
What to check before buying
- Total expense ratio, but also tracking difference, which is the real-world gap between the fund and its index.
- Accumulating or distributing — whether dividends are reinvested or paid out. Relevant to tax outside an ISA.
- Domicile. Irish-domiciled ETFs benefit from a favourable US withholding tax treaty rate on dividends, which for a US equity fund is worth more than most fee differences.
- UK reporting fund status. Without it, gains can be taxed as income rather than capital for UK investors — an expensive trap on some US-listed products.
- Size and spread. A £20m ETF with a wide spread costs more to use than its headline fee suggests.
How you would actually trade it
Buy through any investment platform exactly as you would a share. Deal during the main part of the session rather than at the open or close, when spreads widen and the underlying market may not yet be priced.
For an ETF tracking a market that is closed — a Japanese equity ETF bought at 9am London time — the price you pay reflects market makers' estimate of where Tokyo would be, not last night's close. That is normal, not a mispricing.
US-listed ETFs are generally not available to UK retail investors because they do not produce the required KID documentation; buy the Irish or Luxembourg-domiciled equivalent listed in London.
What goes wrong
- You own the index, including its concentration. A global tracker is now heavily weighted to a handful of US technology companies. That is a real active position arrived at passively.
- Synthetic counterparty risk in swap-based products.
- Securities lending. Many physical ETFs lend holdings for extra income; collateral is posted, but it is an additional exposure.
- Leveraged and inverse ETFs decay. Daily-rebalanced products do not deliver their multiple over any period longer than a day, and in choppy markets lose value even when the index ends flat. They are trading tools, not holdings.
- Closure. Small ETFs get wound up, forcing a taxable disposal at a time you did not choose.
This entry describes how a market works. It is not a recommendation, a price forecast, or advice about whether this belongs anywhere near your money. How entries are written.