Investment Guide: Basic knowledge ETFs

"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds."
Warren Buffett, 2016

Exchange-Traded Funds (ETFs) have become a popular instrument to invest. ETFs track an index, e.g. a stock exchange (like the Dow Jones or the S&P 500) or a bond index. They have become popular due to low costs, tax efficiency, and stock-like features. Learn in this article how to invest in ETFs!

Etf chart

ETFs are a cheap and diversified tool to invest

An ETF is a replica of a stock market index: in the simplest case, a fund company takes the money of the investors and buys for it all those securities, which are contained in the index. Most ETFs replicate share or bond indices, e.g. the DOW Jones or S&P 500. The goal of an ETF is to achieve exactly the return that the index achieves. An ETF does not try to be smarter and better than the broad masses of investors by targeting individual stocks. With an ETF you can easily and cheaply participate in the market, you follow the majority. This strategy brings a big advantage to ETFs: they cost significantly less than funds where a fund manager selects stocks (so-called active funds). Not only do you pay significantly less, if any, commission for brokering (buying) ETFs. The running costs, at best, only account for one-seventh of the costs of active funds. The ETF, therefore, retains more of its actual performance from the outset. The following table shows the comparison of costs between ETFs and actively managed mutual funds.

Cost differences between ETFs and mutual funds
Items ETFs Mutual Funds
Objective replicate reference index beat reference index
Running costs 0.2-0.5% per year about 1.5% per year
Purchase Costs one-time up tp 0.25% one-time up to 5%
Performance-related Fees none up to 20%

Step 1: Build a diversified ETF Portfolio with low costs

The first major thing to understand is the difference between physical and synthetic ETFs.

  • Physical ETFs: Shares are purchased according to their weighting in a stock index. This is possible for indices that consist of a limited number of liquid shares, such as the DOW Jones. However, if the index is very large, such as the MSCI World with more than 1,600 stocks, only certain company shares are bought. This is called partial replication or sampling. In sampling, representative index stocks are selected for replication and this selection is optimized by selecting the individual assets(for example stocks) with the highest correlation to the index. However, they do not have to be index titles. The investor should know two disadvantages: In the partial replication, there are automatically smaller deviations from the index, the so-called tracking error. The physical replica is the more expensive variant and therefore costs more fees. The big advantage: physically replicating ETFs are safer and easier to understand for the investor.
  • Synthetic ETFs: Synthetically replicating ETFs do not hold the underlying values of the index, but use derivatives such as swaps to track the performance of the underlying index and secure these swaps with the help of a security basket. With synthetic replicating funds, fund companies can replicate an index more precisely, that is, with little or no tracking error than with many physical ETFs. In addition, some indices on commodities or certain emerging economies such as India can only be represented by synthetic ETFs because the underlyings cannot be bought or stored economically, such as oil. The involvement of a swap partner creates counterparty risk.

The second major thing to understand is the difference between distributing and accumulating ETFs.

  • Distributing ETF: If a company makes a profit, it is regularly distributed to shareholders as a so-called dividend. If stocks are in a fund, the dividends will first go to the fund. The fund can then pass the dividends bundled to the investors.
  • Accumulating (Reinvesting) ETF: An ETF also has the ability to credit the dividends to the fund's assets. This is referred to as an accumulating or reinvesting ETF. Such ETFs are suitable for investors who want to build up long-term assets. After all, dividends also benefit from a (positive) performance, similar to the compound interest effect.

The third major thing to understand is the difference between the management style of the ETFs.

  • Index ETFs: Most ETFs attempt to replicate the performance of a specific index. Indexes may be based on stocks, bonds, commodities, or currencies.
  • Actively managed ETFs: Most ETFs are index funds, but some ETFs do have active management. Actively managed ETFs were introduced in the United States in 2008. The economic value of actively managed ETFs is questioned because higher fees as well as hidden costs (trading fees, lower return from holding cash) reduce returns for investors.
  • Inverse ETFs: Inverse ETFs use derivatives to profit from a decline in the value of the underlying benchmark. It is similar to holding several short positions.
  • Leveraged ETFs: Leveraged ETFs (LETFs) attempt to achieve daily returns that are a multiple (e.g. 2x or 3x more) of the index, e.g. the Dow Jones Industrial Average or the S&P 500. A leveraged ETF can also be inverted (called bear ETF) and attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market. Leveraged ETFs use of financial engineering, e.g. equity swaps, derivatives or futures.

After having understood the different characteristics of ETFs, the investor must decide which assets he wants to invest in. Therefore, there are different ETFs:

  • Stock ETFs: The most popular ETFs track stocks. Many funds track national indexes; the Dow Jones Industrial Average or the S&P 500. Other funds own stocks from many countries; e.g. the MSCI All Country World ex USA Investable Market Index. Stock ETFs can invest in different manners, e.g. large-cap, small-cap, growth or value (high dividends). Sector ETFs invest in sectors, e.g. finance and technology, or specific niche areas, e.g. green power, or specific countries or global.
  • Bond ETFs: Bond ETFs invest in government or corporate bonds. Their performance might indicate economic conditions as investors will take out money from the stock market and move into bonds when they expect a crisis. Bond ETFs have reasonable trading commissions, fees if bought and sold through a third party might be very high.
  • Commodity ETFs: Commodity ETFs (CETFs or ETCs) invest in commodities, e.g. precious metals (gold), oil or agricultural products. Generally commodity ETFs are index funds tracking non-security indices. Most ETCs have a futures trading strategy, which may produce different results from owning the commodity. As many ETCs use futures, there are costs related (rolling costs). Therefore the ETCs do not necessarily directly follow the commodity. Investors should be experienced and inform themselves well before investing in ETCs.
  • Currency ETFs: Currency ETFs invest in different currencies. As the currency itself does not produce any profits (just like commodities), the investors speculate on changing exchange rates.

ETFs are as safe as actively managed funds: money you invest in ETFs is a special asset and is protected in the event of bankruptcy by the ETF provider. Various studies have shown that only the fewest actively managed funds succeed, even after deduction of all costs, to outperform the general public in the long term.

There are thousands of ETFs to choose from. One important aspect is to look at their relative costs. Each ETF publishes an annual expense ratio. This is the percentage of the fund’s total assets that covers the costs that the ETF incurs every year. Smaller expense ratios more money for you to invest, especially considering the compound interest rate, this is a relevant issue. Many ETFs have expense ratios below 0.1%.

The big providers of ETFs are iShares, Xtrackers and Lyxor. ETFs from these providers can be conveniently purchased through an online depot, which will be explained in Step 2.

Step 2: Choose a brokerage account with low fees

ETFs trade like stocks on the well-known major stock market exchanges. To trade on an exchange you need a broker with the respective brokerage account. The choice of the broker should be made taking into account the ETFs you want to invest in. Many brokers offer special deals with no commission for certain ETFs. The main items that should be considered when choosing your broker are costs, trustworthiness & reliability, usability, customer service, investment options, guides & training courses, tools, information and apps. When you complete the Investment Canvas, we will give you a selection of brokers that fulfill the demands of your personal investment strategy that you defined in the Canvas. More details on the brokers can also be found in our Academy article “Implementation“.

Step 3: Keep investing continuously

As we know from The Basics of Investing from the Academy, the crucial part of investing is to do it continuously. Some brokers will allow for special saving plans, some even without paying any fees for regular purchases. This will enable you to constantly invest. Through constant investment you will get used to the regular payments and adjust your lifestyle accordingly. The money will sum-up more quickly on your investment account than you thought which will give you further motivation to continue investing!

Summary

ETFs have certain advantages to mutual funds and single stocks. By principle, they are diversified and therefore less risky than investing in single stocks. Moreover, they are cheaper than mutual funds. Therefore, ETFs have become more and more popular for novice investors. Novice investors should stick to simple products that they understand, e.g. index funds of major indices like the Dow Jones Industrial Average or the S&P 500. The right choice of a broker can help to significantly reduce costs. Also, regular saving plans are offered by some broker, which help to implement the investment strategy.