An exchange-traded fund, commonly known as an ETF, is a managed investment fund whose units can be bought and sold on a stock exchange.

The fund pools investors’ money and uses it to obtain exposure to assets such as shares, bonds, property, commodities or currencies.

Many Australian ETFs passively track an index instead of employing a manager to select individual investments. An ETF following the S&P/ASX 200, for example, aims to reflect the performance of many of Australia’s largest listed companies.

Other ETFs are actively managed, concentrate on a particular theme or use derivatives to reproduce the performance of an asset.

Owning an ETF does not mean the investor directly owns every underlying share or bond. The investor owns units in the fund.

Returns may come from changes in the unit price and distributions paid by the fund. Both can vary, and invested capital is not guaranteed.

ETFs are often promoted as an easy way to achieve {investment diversification}, but the label alone proves very little.

A broad global-share ETF may contain hundreds or thousands of companies. A narrowly focused fund might hold businesses from only one industry, country or investment theme.

Buying several ETFs can still leave a portfolio concentrated if those funds contain many of the same large companies.

Investors should read the product disclosure statement and examine the index methodology, major holdings, geographic exposure and asset allocation.

International ETFs introduce currency considerations. An unhedged fund may rise or fall in Australian-dollar terms partly because of movements in exchange rates. A hedged fund attempts to reduce that effect but will have its own costs and limitations.

ETFs charge management costs, usually expressed as an annual percentage of the fund’s assets. Investors may also pay brokerage and experience a difference between the price at which units can be bought and sold.

Physically backed ETFs hold some or all of the investments they track. Synthetic ETFs use derivatives and introduce the additional risk that a counterparty may fail to meet its obligations.

Leveraged and inverse funds are considerably more complex. Their results over longer periods may differ sharply from what an investor expects after seeing a simple description of their daily objective.

Before purchasing an ETF, an investor should consider the goal for the money, the investment timeframe and the size of loss they can tolerate.

ETFs can be efficient building blocks, but they are still investments, and every investment requires an understanding of what sits underneath it.