What is an ETF?
What advantages do ETFs offer? How can they be used for investing and what should you look for when choosing an ETF?
The most important facts in brief
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1. Basics
An ETF (Exchange Traded Fund) is an exchange-traded index fund. As the name suggests, ETFs combine three important concepts (fund, index investment and exchange-traded) in one product.
A fund is a strictly regulated financial product that pools money from investors and invests it in the capital markets according to a predefined investment objective. Through a single investment, it is very easy to participate in the performance of a basket of securities. Because the invested money is divided among several securities, the risk of the investment is also spread (diversification). Since price increases and decreases of individual securities can balance each other out, the value of a fund usually fluctuates less than the value of an individual security.
An index fund is a fund whose objective is to replicate a rule based index as closely as possible (for example, share indices such as the S&P 500, DAX or MSCI World). An index represents a basket of several securities (read more in What is an index?). If the prices of the securities in an index rise, the value of the index fund also rises. If they fall, the value of the index fund falls accordingly.
Unlike actively managed funds, with ETFs it is not individuals who make the investment decisions. Instead, the composition of the index determines which securities the ETF invests in and with which weighting. Since no fund management has to be paid for the analysis of the individual securities, the ongoing costs of index funds are usually significantly lower than those of active funds. This lowering of costs has a positive effect on performance.
ETFs are index funds that can be bought or sold on stock exchanges. A stock exchange listing also has the advantage that prices are continuously quoted during trading hours so investors can transparently follow price movements. This contrasts with actively managed funds that are not listed on stock exchanges, which can usually only be traded once a day directly with the investment company. There are also no entry fees for exchange trading.
2. How can ETFs be used for investing?
ETFs are the ideal product to invest savings into the capital markets over the medium to long term. Firstly, because ETFs provide very uncomplicated access to a broadly diversified portfolio. Secondly, because ETFs greatly simplify essential questions concerning the selection of individual securities and their weighting within a portfolio. Below we provide an overview,
- what are the different types of ETFs,
- how a portfolio can be built using ETFs and
- what features you should look for when choosing an ETF.
From the individual ETF to the ETF portfolio
ETFs can be used to invest into numerous asset classes and market segments. The major investable asset classes include shares, bonds and commodities. Investors can choose between ETFs on broad market indices and investments into specific market segments such as countries, sectors or themes. In the case of equity ETFs, for example, a market-wide ETF implies the underlying index contains numerous companies with many different business models. By combining several ETFs, a personalised portfolio can be created at a very low cost.
ETFs on very broad indices in particular are suitable as the basis or core for a long-term portfolio. Using equities as an example, they can be used to invest in the equity markets of industrialised countries (e.g. ETFs on the MSCI World Index) or emerging markets (e.g. MSCI Emerging Markets) with just one ETF. Such ETFs provide access to several thousand stocks from a numerous countries.
The size of the individual positions in an ETF depends on the weighting method of the index being tracked. Most indices are weighted by market capitalisation. The more market capitalisation a company has, the higher its weighting in the index and, therefore, also in the ETF. This can lead to a situation where a few individual stocks in the ETF are responsible for the majority of the performance.
There are also popular equity ETFs on the market that do not weight companies by market capitalisation and/or that enable investments with a special focus. These include:
- Sustainable ETFs consider sustainability aspects in their composition. Sustainability is usually measured in the three dimensions of environmental, social and governance (ESG). Investors should look closely at how well the ESG criteria applied correspond to their own ideas of sustainability. Sustainable ETFs are often identified by name suffixes such as "ESG" or "SRI" (socially responsible investing).
- Regional and country ETFs invest regionally, depending on where the included companies are headquartered or have their home stock exchange. However, since large companies typically sell their products globally, one is usually also exposed to the opportunities and risks of other markets. An ETF on the DAX is an example of a country ETF.
- Sector and thematic ETFs usually invest with a higher concentration in sectors, such as information technology, industry or health. Thematic ETFs invest in companies that operate around a theme such as renewable energy or ageing society (i.e. away from the classic sector classification). An example of a sector investment is an ETF on the Nasdaq 100.
- Factor ETFs are constructed according to the findings of various investment studies. These studies state that with focus on certain factors, an excess return can be achieved versus the broad market. However, this need not be the case in all market cycles. Well-proven factors include small caps (shares of companies with low market capitalisation), value (low-valued shares), and minimum volatility (shares with comparatively low price fluctuations).
Sector mix, but concentration on one country
Top positions of an exemplary ETF on the DAX*
A DAX ETF tracks the performance of the 40 stocks from the German Share Index. The individual shares have the same weighting in the ETF as in the index. Due to the strong focus on German export-oriented companies, the index and thus ETFs on it tend to be less diversified than ETFs based on indices with significantly more shares from several countries and a broader mix of sectors.
*As of March 2023. Source: iShares
Whether ETFs with a special focus are suitable for one's own portfolio cannot be answered unilaterally. However, depending on the structure of the ETF portfolio, they can be a useful component:
- Special attention should be paid to the mix of asset classes when creating a portfolio. Depending on the individual risk-bearing capacity and investment horizon, different allocations are suitable, such as with equity and bond ETFs (for example 70 percent equities, 30 percent bonds). Compared to equities, bonds are generally less susceptible to fluctuations and ensure greater stability of the portfolio (with lower expected returns over a long investment period). In addition, ETFs on other asset classes such as commodities can be added.
- Advanced investors sometimes use a core-satellite strategy to customise their investment. Here, around a broadly diversified basic investment (core) - which makes up the majority of the portfolio - ETFs with a special investment focus (satellites) are added with a lower weighting.
With intelligent additions, investors can diversify their ETF portfolio more broadly or give it an individual touch. In doing so, they should be careful not to unintentionally create cluster risks. For example, an ETF on the MSCI World already contains the companies from a Nasdaq 100 ETF. Putting both products in the portfolio does not diversify, but creates a stronger focus on US technology stocks. Whether this is desirable or not is a matter of individual judgement.
From a risk perspective, the more specialised an ETF is - for example, a country ETF on a very small equity market or an ETF on a niche theme - the more it should be considered as a small addition to the portfolio in addition to ETFs on the broad equity market. Beginners in particular should focus (initially) on market-wide ETFs in order to avoid unintended concentration risks of individual sectors or regions in the portfolio.
ETF selection: What criteria to look for
The previous section dealt with which asset classes and market segments one can invest in with ETFs. Those who have made a decision here usually have the choice between many ETFs from different providers. At first glance, the variety of ETFs can often seem confusing. Below we look at the most important features to help you find the right ETF:
- Tracking method:
An ETF tries to replicate its index as best as possible. In terms of replication methods, a distinction is made between physical and synthetic replication. In the case of full physical replication, investments are made directly in all the securities contained in the index. This is sometimes difficult to do for large international indices with many thousands of securities. For reasons of efficiency, fund companies therefore often use "optimised sampling". The ETF invests only in those securities that best represent the performance of the index. Securities that are too small or illiquid are avoided. This saves the fund unnecessary costs and risks.
Synthetic replication is to be distinguished from physical replication. Synthetically replicating ETFs do not invest directly in the securities contained in the index, but enter into an exchange transaction ("swap") with a large investment bank. In this swap, the ETF receives the performance of the underlying index. In return, the investment bank deposits collateral should it become insolvent. Depending on the asset class and market segment, synthetic ETFs can have advantages. For example, synthetic ETFs on US equities have tax advantages that can lead to better performance. Due to strict regulation and full collateralisation, synthetic ETFs are considered as safe as physical ETFs. - Use of income:
With regard to the use of income, a distinction is made between distributing and accumulating ETFs. If you hold units in distributing ETFs, dividends are paid out to your cash account at regular intervals. Distributions can be made annually, semi-annually, quarterly or even monthly. In contrast, accumulating ETFs reinvest current income in securities automatically. This allows investors to benefit from the compound interest effect and they do not have to reinvest dividends manually. Many ETFs also have several share classes of the same fund. Accumulating share classes are usually marked with an "Acc" or "C" in the name, while distributing share classes are often marked with a "Dist" or "D". - Costs:
The ongoing annual costs are shown as the Total Expense Ratio (TER), which is taken as a percentage of the investment volume. These account for management fees of the fund company, licensing costs for the use of the index and custodian bank fees for the safekeeping of the securities contained in the ETF. Not included are transaction costs for reallocations within the fund or costs for hedging foreign currency risks, if this is done. The TER is deducted directly from the fund assets and is already included in the market prices.
The ongoing costs, taxes at the fund level and the imperfect replication of the index mean that the performance of an ETF may deviate (slightly) from the performance of its index. This deviation is called tracking difference and is measured over a certain time interval. It is shown on the issuer's website or in the ETF's factsheet. - Fund volume:
The fund volume of an ETF provides information about the size of the fund. From a fund volume of approx. 100 million euros, it can be assumed that the ETF can be operated economically by the issuer in the long term. For ETFs with a higher TER (such as thematic ETFs), this threshold can also be lower. Should an ETF be closed due to lower popularity, this is usually not a problem, as investors are able to sell their units via the stock exchange before closure. - Fund domicile:
The fund domicile refers to the country in which the fund is launched. Many ETFs are domiciled in Luxembourg or Ireland. Luxembourg is popular because of its favourable financial legislation. Ireland offers partial tax advantages for issuers. As funds are strictly regulated financial products, domicile is usually irrelevant. However, there may be differences in certain situations. For example, physical ETFs domiciled in Ireland on US equities pay lower withholding taxes (15 per cent) than ETFs domiciled in Luxembourg (30 per cent), which can lead to better performance.
3. Advantages of ETFs
The first ETFs were launched a good 30 years ago. During this time, they have become increasingly popular and are now the entry point for many people to access the stock market. This is largely due to the following features of ETFs.
ETFs are diverse and have low costs. With a choice of over 2,000 ETFs for the Dutch market, it is usually not easy to pick the right product. However, the large selection is a positive sign. Due to the high level of competition, the fees of ETFs have fallen continuously in recent years. This applies to both the running costs and the trading costs. ETFs also give investors the opportunity to put together their own personalised portfolios like professional investors.
ETFs reliably track the market. ETFs allow investors to invest in an entire market segment with a single investment. Although filter criteria and exclusions are possible (for example according to ESG criteria), the selection of individual securities as in active fund management is dispensed with. This has the advantage that the market return can be generated very reliably. The investment does not depend on whether a fund manager outperforms the market (also called "alpha"). Studies show that the vast majority of active fund managers fail to beat their respective passive benchmark over time.
ETFs are transparent. Through ETFs, it is possible to invest in numerous securities at the same time. This is possible with an ETF savings plan from as little as one euro per month. The composition can be viewed on the issuers' website on a daily basis. Due to the rule-based structure of the index, there are no surprises.
ETFs are regularly rebalanced. The issuer takes care of the regular rebalancing of the securities within the ETF. If securities fall out of the index (for example because companies are bought out), these must also be exchanged in the fund. This happens automatically. An active adjustment of one's own investment is therefore not necessary. Regular rebalancing ensures that the components of a (physical) ETF always correspond to the underlying index and thus to the relevant market.
ETFs are safe. Capital invested in funds and ETFs is described as special assets. The assets are kept separate from the fund's administrator, the fund company, and are protected from insolvency. An auditor inspects the fund's books at least once a year. The strict regulatory standards can be recognised by abbreviations such as "UCITS" in the name of the ETF.
It is always worth remembering that ETFs do not protect against the general fluctuations of the capital markets or the poorly diversified composition of a portfolio. In general, money should only be invested in risky asset classes if investors can withstand these fluctuations and do not need to rely on the invested money in the short term.
Florian Faltermeier
Florian is a Portfolio Manager in the Wealth Management team at Scalable Capital and deals with data analysis, portfolio construction and research around capital market and ETF topics. He holds an M.Sc. in Economics with a focus on financial markets and computer science from the Technical University of Munich.
