The market for ETFs or exchange-traded index funds is growing. These passively managed investment instruments are particularly interesting for private investors who are looking for a simple, transparent and convenient investment opportunity. In this article, we explain what ETFs are and how they work. In addition to a general definition of ETFs, we deal with the different types of index funds and the advantages and disadvantages of ETFs. We also deal with the level and composition of the costs of ETFs, as well as the role of the ETF issuer. As well as other important questions: How safe are ETFs actually and for which types of investors are they suitable?
What are ETFs and how do they work?
ETFs are exchange-traded index funds (Engl. E Xchange T raded Fands). What an ETF is and how this popular form of investment works can be easily deduced. These funds are exchanged on the stock market, as the name implies. As a trader, you can buy and sell ETFs any trading day.
GOOD TO KNOW: While actively managed funds aim to outperform the reference index and thus the market, ETFs pursue a different investment strategy: They want to track the performance of the underlying index as precisely as possible .
What types of ETFs are there?
There are basically three ways of categorizing ETFs: by asset class, by replication method and by use of income.
- ETFs on different asset classes
- Physical vs. Synthetic Replicating ETFs
- Distribution or retention?
What does an ETF cost? How does the cost put together?
Since ETFs are passive investment products that do not require fund management, the running costs are lower compared to actively managed investment funds. If you would like to get an overview of how much it costs you to own an ETF per year, you can find out about the so-called running costs (Total Expense Ratio, TER) on the website of the fund provider, in the sales prospectus or in the factsheet. This statistic is expressed as a percentage which represents the annual expense of operating an ETF. The TER consists of the fees for the administration, the safekeeping of the securities, license fees for the replication of the index as well as distribution fees, which are incurred for the distribution or the marketing of the fund, for example for the preparation of prospectuses. In addition, you as an investor incur additional costs for an ETF that are not included in the TER. For example, physically replicating funds incur additional rebalancing costs and synthetically replicating ETFs have swap fees. Of course, there are also fees for trading ETFs in the form of broker fees and spreads (difference between purchase and sale price).
GOOD TO KNOW: ETFs with a low total expense ratio (TER) do not necessarily generate a higher return than ETFs with higher ongoing costs.
What are the pros and cons of ETFs?
ETFs are considered to be inexpensive, transparent, broadly diversified, but also flexible, liquid and individual forms of investment.
ETFs are cheaper than other types of funds because the administrative effort is relatively low and therefore there are hardly any costs for ETF management. There is also no issue fee, which is partially charged for “entry” into an actively managed fund. ETFs guarantee transparency by always referring to a specific index – its composition is usually known and you can track its performance on a daily basis without having to look at your portfolio. However, ETFs are not all about advantages. Since index funds develop in parallel with the underlying indices, they are also subject to the same fluctuations – investors have to withstand this volatility in ETFs.
Advantages of ETFs
- Comparatively low fees
- Transparent and tradable every trading day
- Wide risk diversification possible
- Individual investment strategy can be implemented
- Largely protected as a special fund
Disadvantages of ETFs
- Fluctuations in value are unavoidable
- Risk of loss present
- No guaranteed profits
- No individual investment decisions
- Little opportunity to influence
How safe are ETFs?
The question of how secure ETFs are does not have a general response. They are covered as special properties in the case of the insolvency of the fund company or the custodian bank. But be careful: Exchange-traded index funds are also subject to normal market fluctuations and offer no protection against possible losses. With passive fund products, however, the broadly diversified indices may result in a lower risk than with investments in individual stocks.
What does an ETF issuer do?
An ETF issuer is the publisher of ETFs. He compiles ETFs on various indices and makes them available for exchange trading. Of course, the issuer also decides on the replication method and the use of income from the ETF. So whether the underlying index is replicated physically or synthetically and whether the dividends are distributed or reinvested. Even if ETFs are not actively managed, the issuer ensures that the composition of an ETF always corresponds to the reference index.