What should you look out for when buying an ETF. When choosing a stock ETF (index fund) there are a few things to keep in mind. In this article we explain important selection criteria.
The essentials in brief:
- An ETF tracks an index. The more stocks the index contains, the better the risk diversification. So you can easily invest in over 3,000 stocks worldwide.
- The lower the cost, the better. It doesn’t have to be more than around 0.5 percent per year, and in many cases only around 0.2 percent per year is required.
- The fund shouldn’t be too small. If the assets under management in an ETF are over 500 million dollars, there is less risk that the fund company will close the fund at some point.
Compared to actively managed investment funds or certificates, ETFs have a simple structure and are very transparent. Nevertheless, it is advisable to think about a few key criteria before buying. These are the most important:
The index shown
An ETF only passively tracks an index instead of actively pursuing its own strategies. It is all the more important that investors make sure that they choose the right index for their investment objective when buying a product. Some indices contain only a few stocks or are calculated according to criteria that are difficult to understand. This is often the case with so-called strategy indices. These try, for example, to combine stocks with particularly high dividend payouts or particularly high-growth companies in one index. Private investors should basically concentrate on established indices from large providers that cover the largest possible part of the market and are systematically structured.
ETFs from various providers exist for all of the indices mentioned. Bond indices are generally less well known than equity indices. But the same applies here: Investors should look what is in an index. The remaining terms of the bonds included, the creditworthiness of the issuer and the currency in which the bonds are listed are important. Corresponding information can be found on the websites of investors or in financial information portals on the Internet.
Basically, almost all ETFs are cheap. Actively managed equity funds often charge an administration fee of 1.5 percent per year – or even more. For ETFs, on the other hand, the management fee is usually well below half a percentage point per year. Nevertheless, the same applies here: It is important to compare the products of several suppliers. For example, there are providers who expressly reserve the right to pay sales commissions to banks and other fund brokers in the fund prospectus. Such commissions can result in higher costs that investors ultimately have to bear.
Another factor: the more exotic the index that an ETF tracks, the higher the costs in the form of the management fee. This is other reason shows, why you should limit your investments to common indices as far as possible.
The type of income used
Equity ETFs regularly receive dividends from the companies whose stocks they hold. Bond ETFs receive interest payments from the issuers of the bonds they hold. Like other mutual funds, ETFs differ in what they do with that income. There are basically two options: distribute or reinvest. Distributing ETFs pass dividends and interest directly on to investors once a year. The money is then posted to the investor’s account. He then has to decide what to do with it. If you want to reinvest the distributed funds directly, costs can arise – for example through stock exchange fees. Reinvesting ETFs, on the other hand, reinvest the funds they have received in stocks or bonds. Interest and dividends are reflected in higher share prices. So the money stays in the fund and investors don’t have to worry about reinvesting it. However, they also have no current income.
Distributing and accumulating ETFs can also differ in their tax treatment. If you want to be sure about this, you should ask your tax advisor.
The fund volume
A simple rule applies to this criterion: a fund should not be too small. Because: The lower the assets managed in an ETF, the greater the risk that the fund company will eventually close the fund. While this is not a catastrophe, it can create additional costs for reinvesting funds. Larger providers have an advantage in this regard, because their funds often also manage more funds. And widespread indices are once again better than exotic ones. You should therefore always find out in advance how large the volume of the index fund is in which you want to invest. You should also note that the securities from widely used indices are traded significantly more than those from exotic indices.
Building the Fund
ETFs track indices in three main ways:
- Either they actually hold all stocks in an index directly – in the same proportion as they are represented in the index. This process is called full replication. It is usually not offered because full replication is expensive, especially for very large indices that also contain many smaller stocks.
- In most cases, the funds only contain a section of the stocks in the index, supplemented by a few derivatives. Then one speaks of an “optimized” replica.
The third important process is synthetic replication. An ETF directly holds any securities that have nothing to do with the index and concludes a contract (swap agreement) with a bank at the same time. In it, it undertakes to compensate for the differences between the performance of the index and securities on the basket held by the fund.