I wish I knew what ETFs were, but I’m too embarrassed to ask

Exchange-traded funds (ETFs) are bought and sold on a stock exchange in the same way as you would trade normal shares. Unlike investment trusts, which are also traded on exchanges, ETFs are mostly (though by no means all) passively managed. This means their aim is to track the performance of a particular market, rather than beat it, as an active fund attempts to do. Also unlike investment trusts, the net asset value of an ETF should not diverge from its share price, barring extreme circumstances.

ETFs are available on a range of indices, sectors, themes and commodities, and index providers constantly launch new indices for them to track.

Given their largely passive structure, ETFs tend to have lower fees than active funds, and rampant competition between providers has driven prices ever lower. That said, it has also encouraged ETF providers to find ever-more niche indices to track to justify charging higher fees.

ETFs come in two main types: “physical” and “synthetic”. A physical ETF invests in the assets it tracks. For example, a FTSE 100 ETF will invest in FTSE 100 stocks in proportion to their weighting in the index itself. A synthetic ETF instead agrees a “swap” with a third party – typically an investment bank – which agrees to pay the ETF a return based on the index performance.

Many investors prefer physical ETFs, seeing them as less vulnerable to unexpected risks, such as the danger that the counterparty to the swap won’t pay out. However, synthetic ETFs based in the UK and Europe must hold collateral to back these swaps, which means the risks should be limited.

Physical ETFs are arguably more transparent than synthetic ones, but there are some situations in which the latter may be superior. For example, when investing in certain emerging markets, some of which restrict foreign ownership, a swap structure may be cheaper than directly investing in the underlying shares.