Say you buy one share of an exchange-traded fund (ETF) that follows a world stock index. Your account now shows a single line: the fund’s name, a price, and the number of shares you hold. It looks like you bought one thing. In a way you did. But behind that line sit hundreds or thousands of companies, and through the fund you own a small slice of each.

The fund is a container

An ETF pools money from many investors and uses it to buy a list of investments, usually stocks or bonds. When you buy a share of the fund, you are buying a share of that pool. If the fund holds 1,500 companies, you hold a sliver of all 1,500, in the same proportions the fund does.

You don’t get a vote at each company’s annual meeting or a letter from each one. The fund takes care of that. What you get is simpler: the value of your share rises and falls with the value of everything inside it.

Most ETFs follow an index

An index is a published list built on rules, such as “the largest companies in developed countries, weighted by size.” The index provider keeps the list up to date, and the ETF’s job is to hold what is on it as closely as it can. Nobody at the fund decides that a company looks cheap this month. That is why these funds are called passive, and it is a big part of why they cost so little to run.

The practical upshot: when you choose an ETF, you are mostly choosing an index. Two funds that follow the same index will hold nearly the same things. What separates them is usually cost, size, and small details of how they are run.

Where your money is kept

The fund’s investments are held by a separate institution, called a custodian in the US and a depositary in Europe, not mixed in with the fund company’s own money. If the company running the fund got into trouble, the investments would still belong to the fund’s investors. Regulated funds in the US and the EU are required to work this way.

Not every product that trades on an exchange is built like this. An exchange-traded note (ETN), for example, is a promise to pay from the bank that issued it, so you depend on that bank staying sound. Check that what you are buying is a fund.

Buying and selling

ETF shares trade on a stock exchange, so you buy them through a broker during market hours at the current market price. That price stays very close to the value of what the fund holds, because large trading firms step in whenever the two drift apart. You pay your broker’s fee, if there is one, and a small gap between the buying and selling price called the spread. For large, popular funds the spread is usually tiny.

Four things to check before you choose

  • Which index it follows. This decides what you actually own.
  • The yearly cost, listed as the TER or ongoing charges.
  • Fund size. Very small funds are more likely to be closed down.
  • Accumulating or distributing: whether dividends are reinvested for you or paid out.

Harust’s fund research shows all four for every fund, with the factsheet and date each figure came from.