They are in the trend: exchange-traded index funds, or “exchange-traded funds” in short: ETFs. This refers to funds that track the performance of well-known stock market indices such as Dax, NYSE, NASDAQ or S & P 500. More than 1,300 ETFs will be available on the Frankfurt Xetra exchange in 2018 alone.
With ETFs it is possible for every private investor to take the investment into their own hands. An online depot is sufficient to participate easily and cheaply in the stock market and to build long-term assets. Today, every seventh dollar Americans invest in funds is in ETFs.
What are ETFs and how do they work?
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 are shares or bonds.
Let’s take, for example, the German stock index Dax: This index indicates how much the 30 largest companies in Germany are worth. An ETF depicting the Dax would now buy exactly those 30 stocks – and then develop as well as the Dax.
Investors invest “in the market”
A stock index often sums up those companies that are most valued on the stock market – that is, their stock price multiplied by the number of stocks gives the largest amount (stock market value). These are also the most popular companies among the broad masses of investors. It is therefore also said that a stock index “reflects the market”.
The goal of an ETF is to achieve exactly the return 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.
Which stocks end up in the index is reviewed several times a year. If the composition of the index changes, the ETF will also improve.
Exchange traded funds are incredibly cost-effective
This strategy gives ETFs a major advantage: they cost significantly less than funds where a fund manager selects stocks individually (known as active funds). Not only do you pay significantly less, if any, commission for brokering (buying) ETFs. On top of that, running costs only account for one-seventh of the costs of active funds. The ETF therefore retains more of the actual performance from the outset.
Cost differences between active and passive funds
|Passive Index Funds||Active Equity Funds|
|Investment objective||Replica of a reference index||Beat the benchmark index|
|Running costs||About 0.2 to 0.5% per year||About 1.5% per year|
|Acquisition cost||One time up to 0.25%||One time up to 5%|
|Profit sharing||Not applicable||Up to 20% of the annual return|
Various studies have shown that only the fewest actively managed funds manage to perform better than the general public even after deduction of all costs. This is another reason why FFM recommends exclusively exchange-traded funds for equity investment.
If you would like to read more about how ETFs relate to individual costs, please read on in the Costs section below.
Different types of ETFs
Index funds have different approaches to tracking a stock index: There are two different types of ETFs. The way in which investors participate in corporate profits (dividends) may vary.
If an ETF simply trades the securities (stocks) in the index, professionals talk about a physically replicating ETF. They are usually very popular with investors because they are understandable and transparent: Investors always know exactly in which securities they have just invested money in. It can also happen that an ETF does not actually buy all stocks, but only an optimized selection or sampling.
Instead of repurchasing stocks one at a time, the ETF provider can also get the desired performance from a bank. In return, the bank receives a basket of well-known shares from the ETF provider. This exchange can be cheaper for both parties at the end.
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. He can then pass the distributions bundled to the investors. This reduces the value that is in the fund. For example, investors can pay taxes with the dividends, for example.
An ETF also has the ability to credit dividends to the fund’s assets. One speaks then of a reassigning or accumulating 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.
If you want to understand more about how physical and synthetic ETFs differ, read on below.
Which exchange traded fund does FFM recommend?
Calculations have shown that investors who have invested in a globally oriented equity index fund in the past 15 years have never lost money. The reason behind this is that such an ETF distributes the risk of loss to many shoulders and thereby offsets it.
We therefore recommend that you invest long term in an ETF covering the global equity market and reinvesting dividends. In question are ETFs that track the following stock indices.
- MSCI World: It covers the more than 1,600 largest stocks in the industrialized world.
- MSCI All Countries World: It brings together more than 2,500 stocks in the industrialized world and from emerging markets such as China, India and Brazil.
- MSCI Socially Responsible Index: Contains the stocks of about 400 companies that operate sustainably – paying special attention to the environment, social standards and management.
ETFs: simple, transparent, flexible
- Index funds are also known as ETFs.
- They track stock market indices.
- That’s why they are inexpensive.
- Index funds offer long-term high return opportunities.
Good sustainable investment funds
- include companies that pay attention to the environment, social standards and corporate governance.
- exclude companies that tolerate child labor or produce weapons.
- risk of loss should be spread among enough companies and be cheap.
Who is behind the ETFs
ETFs are usually launched by banks and special fund companies. In Europe, ETFs of the iShares brand, which belong to the asset manager Blackrock, are the largest in Europe. These are followed by Xtrackers ETFs, which are majority owned by Deutsche Bank through the fund company DWS, and Lyxor ETFs belonging to the French Société Générale.
In German-speaking countries, the ETF brand Comstage is known, which originally belonged to Commerzbank, but in the fall of 2018 it is expected to go to the Société Générale. British ETF providers are SPDR and Source.
Criteria for the recommendation
The deciding factor for our recommendation was that the ETF had been available on the stock exchange for more than five years, more than $100 million investor money was invested and important investor information on the product was easily available to people.
A certain time is needed to evaluate an ETF and in order to be able to verify that the ETF has actually hit the performance of the underlying index. A certain amount of investment is needed so as not to risk the ETF provider is withdrawing the index fund from the market because it is not worth it.
On the other hand, the running costs of an ETF are not a recommendation criterion. FFM calculations over the past few years have shown that ETFs with lower ongoing costs did not systematically generate more return every year than more expensive ETFs.
For example, some ETFs lend some of the stock to other banks at short notice, which adds value. Or they manage to get more withholding tax. In case of doubt, the higher costs are worthwhile.
In the end, it is important that the ETF comes close to matching the performance of the so-called net index. This is achieved by all of the recommended ETFs. The net index takes the value of all stocks, subtracts withholding taxes and adds dividends.
Where and how can you buy exchange traded funds?
If you want to buy ETFs and then keep them safe, you do not have to go to the branch bank. You can save yourself the fees that banks often charge for the securities account. Instead, open a free online depot with a direct bank or securities trader on the Internet a so called online broker.
We recommend either depots, where you can buy and sell ETFs very cheap, or very practical deposits.
Trade securities low-priced
· High order costs reduce the return.
· Online banks and brokers have favorable offers.
· Use the direct trade.
Ordering ETFs made easy
Once you have opened the portfolio and decided which stock index you want to invest in, you have almost made it. All you need to do is enter the Securities Identification Number (ISIN) or Identification Number (WKN) in the search function of your depot and follow a few simple steps. The number can always be found in our ETF recommendations in brackets.
Exit time is crucial
Basically, you have the option of investing a larger sum all at once or, for example, save it monthly or quarterly in smaller installments in an ETF savings plan. And it does not really matter when you start to save: the main thing is to stay with it for the long term. More important, however, is the exit time.
For example, if you know that you will need your ETF savings in five years, you should not trust that stock prices will be high at that time. Instead, it’s a good idea to gradually reduce your ETF assets – that is, to sell ETF shares – and park the money you have raised on a well-timed overnight money account.
ETF: simple, transparent, flexible
· You can save on ETF savings plans on a regular basis.
· Savings plans offer good yield prospects.
· Changes are possible at any time.
· We recommend stock fund savings plans.
ETFs as a third building block of investment strategy
FFM recommends ETF savings in the context of the investment in addition to a good daily allowance and fixed deposit. How much you invest depends on your budget and your sense of risk. Would you like to know more, you can look at the different sample portfolios, that I will come up with and share here soon.
For example, in the yield-oriented portfolio, we assume that savers park around 20 percent of their savings in a call money account in order to be liquid when urgent purchases are required. The remaining 80 percent are invested in globally oriented exchange-traded funds. Such a portfolio has never lost in the past over a 15 years time-frame.
How safe are ETFs?
Basically, for each fund and also for ETFs: money that is in fund units is special assets and protected. So you do not have to worry: if your ETF provider goes bankrupt, your funds will continue to be yours.
In detail, the law requires that fund companies keep their clients’ money (their fund units) separate from the company’s assets. They usually deposit these with independent custodians. In the case of the ETF providers Xtrackers and iShares, this is, for example, the State Street Bank in Luxembourg or Ireland, and the ETF provider Comstage is with the BNP Paribas.
This prevents the investor’s assets from falling into bankruptcy estate in the event of a bankruptcy of the fund company and claims from creditors are served therefrom. The curator will then be required to manage the ETF – either permanently or until another ETF provider buys the shares.
If it is not the fund management company that is insolvent but the custodian bank, it is required by law that fund units be transferred to another trustee, who then acts as the new custodian. Such an incident should not bring you any harm.
If your online bank or broker with whom you hold your personal securities account should fail, there is no reason to panic either. A trustee would take over your deposit and serve as a new contact.
Are physical ETFs safer than synthetic ones?
Many investors can better imagine that an ETF provider simply replicates (physically replicates) index stocks – and considers it safer. On the other hand, it is difficult to understand the share swaps of synthetic funds. Some fear that they will not get back the full index value in the event of a bankruptcy of the ETF provider.
In the end, the risk of losing money in the event of bankruptcy of one participant (ETF provider, bank as an exchange partner) is very low for both ETF types – and very theoretical. In detail:
Example: Physical ETF
The ETF provider does not always buy all stocks in the index. For broadly diversified indices, such as the MSCI World, the ETF provider maintains an optimized selection of stocks sufficient to adequately index the performance of the index. At the same time, the ETF provider will lend portions of its stock to other market participants, such as securities dealers or investment banks, who need short-term stocks. This is how the ETF adds a little bit and can get more return for investors.
The securities lending itself is secured and strictly regulated. For example, a trader borrowing shares from the ETF provider must deposit collateral such as government bonds. As a rule, at the end of each trading day it is then checked whether the deposited government bonds still correspond to the value of the shares. If they do not do that, the security trader has to go after collateral. This is to ensure that the value of the ETF remains close to the index value at all times, in spite of securities lending.
Example: Synthetic ETF
ETF Provider A has been swapped out by the swap partner Bank B for the performance of the world stock index MSCI World. In return, A builds up a so-called bearer portfolio with a number of well-known, frequently traded stocks and in turn secures this performance to Bank B. Different developments balance the partners regularly. A problem could arise if Bank B went bankrupt and could no longer deliver the performance of MSCI World to ETF Provider A as agreed.
Then ETF provider A would have to fall back on its own equity portfolio and make this money. Should the basket of equities be less valuable than the MSCI World, vendor A would have to tap and sell the collateral deposited by Bank B for this purpose – usually government bonds or cash holdings. In Europe, it is strictly regulated that differences in the value of the two portfolios, the so-called swap value, must always be secured. Since March 2017 even up to 100 percent. The swap value is determined daily and collateral is drawn.
This is how physical and synthetic ETFs differ
|Physically replicating ETFs||Synthetic ETFs|
|The ETF holds nearly all stocks represented in the original index (optimized sampling).||The ETF provider allows index development to be secured by a bank through a swap transaction. He himself builds a carrier portfolio with shares of large companies.|
|To generate more revenue, the ETF provider gives shares in the capital market.||ETF providers use barter deals because they can replicate the development of the index more cost-effectively.|
|Securities lending is collateralised and usually settled daily.||The barter transactions are secured. In the event of bankruptcy, the ETF provider’s portfolio and collateral, mostly government bonds, will be liquidated.|
Note: Both ETF types – like any other equity fund – are generally exposed to the risk on the stock market. If shares in the fund must be sold, investors will only ever receive the money that these shares are then worth on the market.
Are ETFs riskier than active mutual funds?
The more popular ETFs become, the more critical voices are heard. Often the question arises as to whether it is riskier to invest in ETFs than in traditional equity funds. To start with, if you are investing in an ETF that does not track a niche market, but a well-known, big stock index, you have nothing to worry about.
These are the main criticisms and our answer on that subject matter:
- ETFs are strengthening the downturn with their market power
When investors withdraw money in a downturn, ETFs must sell stocks. That’s true. However, the actively managed funds are the same. The reason for a slowdown is less the funds, but rather the “pro-cyclical” behavior of many investors in panic selling. Therefore, the appeal: Stay calm and invest with a long term strategy in mind!
- ETFs hold too little cash and in a down phase you will not get rid of your shares
ETFs typically hold less cash reserves than actively managed funds. Nonetheless, it is unlikely that the dedicated ETF traders (market makers) engaged on behalf of the ETF fund management company will be able to withdraw their ETF shares. This could only happen if the ETF is invested in illiquid niche markets where hardly anyone trades. The ETF company would then sell the stocks deposited with the ETF on the market, or only at very low prices. If an ETF targets the largest stock indices in the world, this is not to be feared.
- ETFs invested on MSCI World are risky because they are denominated in dollars
Some of the MSCI World ETFs, like the index itself, are denominated in US dollars. There is a currency risk against the Euro in the sense that a Euro investor may not fully benefit from the positive performance of the Dollar ETF. He must always accept “discounts” if the euro has appreciated in line with the (positive) performance of the index.
However, over extended periods of time, exchange rate changes are not all that significant, as experience has shown. Investors should also value the broad diversification of investments. This does not create an index better than the MSCI World, which brings together 1,600 individual issues from 23 countries. Our calculations show that even a retrospectively converted to Euro World Stock Index has increased its value over the past 45 years on average by a good 7 percent each year.
In our blog post we analyzed further criticisms of ETFs.
How are the costs of ETFs exactly related?
Investors who are more interested in the cost of ETFs may look at the Total Expense Ratio (TER) in the prospectus or on the overview pages on the internet. It expresses how many percentage points the costs reduce the annual return – and is therefore also called the total cost ratio or effective cost ratio.
The TER covers the flat fee charged to the ETF for administration, custodian and investor information. There are also VAT and other minor fees. ETF providers value the TERs and typically derive them from the fund’s assets on a monthly or quarterly basis. For ETFs, the TER is usually between 0.1 and 0.5 percent per year.
Not included in the TER are transaction costs that the Fund has to pay when buying and selling securities. The actual cost of the ETF is therefore always slightly above the TER, which is calculated for the past financial year.
What do you have to pay attention to with the tax?
How exactly certain ETFs are taxed was, until 2017, still a criterion for the selection of certain ETF types. Sometimes it was necessary to add laboriously manual information in the tax return. Since 2018 you have made it much easier.
Since then, the new law on investment taxation is in force. For the first time for the calendar year 2018, all investment funds (mutual funds) will be subject to withholding tax according to the same logic. It no longer depends on the country in which a fund is set up and whether it distributes or spends dividends.
According to a specific formula, your custodian bank calculates an annual assessment base for the final withholding tax of a good 25 percent. The tax will be withheld directly, unless you submit an appropriate exemption order to your custodian bank. Capital gains are tax-exempt up to a certain amount for individuals and up to double the amount for jointly-taxed persons.
I hope this gives you a good overview on ETFs and I hope you will share this with other folks in your community. If you have questions on the subject of ETFs feel free to ask them in the comment box below.