What is an ETF and How Does it Work — Beginner Guide

01 Basics

What is an ETF and how does it work?

ETF stands for Exchange-Traded Fund. The idea is simple: an ETF is a basket of many different stocks or bonds packed into one product that you can buy like a regular stock.

Instead of buying Apple, Microsoft, Amazon and 497 other companies separately — you buy one S&P 500 ETF that holds all of them at once. One purchase, instant diversification.

How does it work in practice?

1

The fund buys stocks

The ETF provider (e.g. Vanguard, iShares, SPDR) buys stocks or bonds according to a chosen index, e.g. S&P 500 — the 500 largest companies in the USA.

2

The fund issues units

For every 100 you put into the fund you get ETF units — small pieces of the entire basket.

3

You buy and sell on the exchange

An ETF trades on the stock exchange like a regular stock — you can buy and sell it at any point during the trading day through a brokerage account.

4

Value grows with the market

When companies in the index grow, so does the value of your ETF. When companies pay dividends, an accumulating ETF reinvests them automatically (or a distributing ETF pays you cash).

An ETF does not go bankrupt together with the fund provider — your stocks are legally separated from the management company's assets. Even if iShares were to collapse, your units are safe.

02 Types

What types of ETFs are there?

There are hundreds of types of ETFs on the market. The calculator includes the most popular ones — it is worth understanding the differences between them.

By what they track

🌍

Stock (index) ETFs

The most important category. They track stock market indices — e.g. MSCI World (1,600 companies from 23 countries), S&P 500 (500 largest US companies). Historical return: around 7–10% per year.

📋

Bond ETFs

Track baskets of government or corporate bonds. Safer than stock ETFs, but lower return (around 2–5% per year). They stabilise a portfolio during market swings.

🥇

Commodity and metal ETFs

Track the price of gold, silver, oil, gas or a basket of commodities. Gold often rises when stocks fall — popular as a portfolio hedge.

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Real estate ETFs (REIT)

Track companies managing commercial real estate — office buildings, logistics warehouses, data centres. They pay regular dividends.

Accumulating vs distributing

Accumulating (ACC)

Dividends automatically reinvested

Compound interest works at full power

No tax on dividends along the way

Better for long investment horizon

Distributing (DIST)

Dividends paid out as cash

Regular passive income

Tax on each dividend payment

Better when you need regular cash

Tip: If you are investing for the long term and do not need regular payouts, choose accumulating (ACC) ETFs. In the calculator the DRIP option simulates exactly this behaviour.

03 Costs

TER — the fee that matters

ETFs are cheaper than actively managed funds — but they are not free. The key fee is TER (Total Expense Ratio) — an annual management fee automatically deducted from the fund's value.

0.07%

Vanguard FTSE All-World (VWCE)
— one of the cheapest global ETFs

0.20%

Typical sector
or thematic ETF

1.5–2%

Typical actively managed
investment fund

At first glance 0.2% is nothing. But on 100,000 over 20 years the difference between a TER of 0.07% and 0.5% amounts to several thousand. You can check this in the calculator by turning on the TER option.

When choosing an ETF, always check the TER. For ETFs on major indices (S&P 500, MSCI World) a good TER is below 0.2%. Anything above 0.5% is expensive.

04 Risks

What an ETF does not guarantee

An ETF by itself does not guarantee a profit — it mirrors the market. If the index falls, the ETF falls too. Here is what you need to know before you start.

Volatility — prices move every day

The value of a stock ETF can fall by 30–50% during a crisis. This is not a failure — it is normal market behaviour. Historically every major crash on the main indices has been recovered. The key is your investment horizon — the longer it is, the less short-term volatility matters.

Currency risk

Most global ETFs are priced in dollars or euros. When your local currency strengthens against the dollar, the value of the ETF in your currency falls — even if the index itself is rising. Over the long term currency effects tend to even out, but it is worth being aware of this.

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What ETFs do well

Diversification — one global ETF gives you exposure to thousands of companies. Low costs — TER several times lower than active funds. Simplicity — you buy one product and hold it for years.

⚠️

What ETFs do not do

An ETF does not protect against drops — when the market falls, the ETF falls too. There is no guaranteed return or capital protection. It requires patience and the ability to sit through temporary losses.

The most common mistake: selling an ETF during a crash and locking in the loss. Historically investors who did nothing during crises earned more than those who tried to get out and back in at the right time.

05 Practice

How to try an ETF in the calculator

You now know what an ETF is, how it works and what makes it different from other products. You can now go to the calculator and see how a specific ETF would perform in your portfolio over 10, 20 or 30 years.

1

Open the calculator

Go to the home page and click "Add instrument". Type "MSCI World" or "S&P 500" in the search box — that is a good starting point.

2

Set 100% allocation

A single global ETF at 100% is a complete, diversified portfolio. You do not need to add anything else when you are just starting out.

3

Turn on TER and tax

Enter your ETF's TER (you can find it on the product page on the provider's website). Also turn on capital gains tax to see the real net result.

4

Calculate and analyse

Click "Calculate portfolio results". Check the final value, the Monte Carlo chart and historical crashes — you will see how this ETF behaved during the biggest market crashes in history.

Not sure where to start? In the portfolio builder click "Passive example" — it will load a ready-made portfolio based on a proven passive strategy with a few ETFs.