What is an ETF? A simple guide for beginners

If picking individual companies feels daunting, an ETF may be the place to start reading. ETFs are one of the most common ways for people around the world to invest in many companies at once. This guide explains what an ETF is, how it works, what it costs and how it compares with buying single shares.

What an ETF is

ETF stands for exchange-traded fund. Let's take the name in parts:

• Fund: a pot of money from many investors that is used to buy a collection of investments, such as shares in many different companies.
• Exchange-traded: the fund itself is listed on a stock exchange, so you can buy and sell it during the trading day, just like a share.

When you buy one unit of an ETF, you own a small part of the whole collection. If the fund holds shares in 500 companies, your one unit gives you a tiny slice of all 500.

How an ETF works

Most ETFs follow an index, a list of companies chosen by a fixed rule. An index might track the largest companies in a country, the companies in one industry, or a region of the world. The ETF buys the companies in that index, in roughly the same proportions, so its value moves up and down with the index.

For example, an ETF that tracks an index of large US companies would rise when those companies' shares rise overall, and fall when they fall. You do not need to choose which companies to hold; the index decides that.

Some ETFs are actively managed, which means a manager chooses the investments rather than following an index. These usually cost more.

ETFs can hold more than shares. There are ETFs that hold government bonds, company bonds, commodities such as gold, or a mix.

Why beginners often look at ETFs

• Spreading risk. One ETF can hold dozens or hundreds of companies. If one company does badly, it has a smaller effect on your total. This is called diversification.
• Simplicity. You do not need to research every company. You choose the market or theme you want to follow.
• Low costs. Index ETFs often charge low yearly fees compared with funds where a manager picks investments.
• Transparency. Most ETFs publish what they hold, so you can see exactly what you own.
• Easy to buy and sell. Because they trade on an exchange, you can usually buy or sell during market hours.

ETFs compared with single shares

Buying a single share means owning part of one company. If that company does very well, your investment can grow faster than the market. If it does badly, you feel the full effect.

Buying an ETF spreads your money across many companies. You are unlikely to beat the market by a wide margin, because the ETF is designed to follow it, but you are also less exposed to any one company's problems.

Many investors use both: an ETF as the core of their portfolio, with a few single companies they believe in. If you want to understand single shares first, read What is a share?

What ETFs cost

ETFs are not free. The main costs are:

• The expense ratio, a yearly fee shown as a percentage of what you have invested. It is taken from the fund automatically, so you do not get a bill, but it reduces your return. Fees vary widely between ETFs.
• Trading fees charged by your broker or app each time you buy or sell.
• The spread, the small difference between the price you can buy at and the price you can sell at.
• Currency costs, if the ETF is priced in a different currency from the one you pay in.
• Taxes on any dividends the ETF pays out.

Compare the total cost, not only the trading fee, before you choose.

The risks of ETFs

An ETF spreads risk but does not remove it.

• Market risk. If the whole market falls, an ETF that follows it falls too.
• Narrow ETFs. An ETF that follows one industry or theme holds companies that tend to rise and fall together, so it can be almost as risky as a single share.
• Currency risk. An ETF priced in US dollars changes in kwacha value when the exchange rate moves.
• Complex products. Some ETFs use borrowing or derivatives to multiply daily moves. These are designed for short-term traders and can lose money quickly. Read what an ETF does before buying it.

How to choose an ETF

Questions worth asking:

1. What does it track? Read the name and the fund's fact sheet. Know which index or strategy it follows.
2. How many holdings does it have? More holdings usually means more spreading of risk.
3. What does it cost? Check the expense ratio and your provider's fees.
4. What currency is it in? Think about how exchange rates could affect you.
5. Does it pay out dividends or reinvest them? Some ETFs pay dividends to you; others reinvest them automatically.

ETFs in Malawi

Most of the world's ETFs are listed on exchanges abroad, such as in the United States and Europe. Our guide to investing in US stocks from Malawi explains the routes people in Malawi use to invest abroad. For the local market, read our beginner's guide to the Malawi Stock Exchange.

With Ziki, you can invest in shares from your phone and pay with Airtel Money, TNM Mpamba or USDC. Ziki's short lessons and practice mode with virtual money can help you get comfortable before you invest real money.

Key points

• An ETF is a fund that holds many investments and trades on a stock exchange like a share.
• Most ETFs follow an index, so you do not have to pick individual companies.
• ETFs spread risk and are often low cost, but they still go down when markets fall.
• Check what an ETF tracks, what it costs and what currency it is in.

Next, read how to buy shares in Malawi, or see how Ziki works.