ETF 101

• 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.

• 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. 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.

• 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 no entry fees for exchange trading.

• 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).

• 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.
• Example: An 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.

• 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).

• Example: An ETF on the Nasdaq 100

• 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).

• 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).
  • ETFs on other asset classes such as commodities can be added.

• Advanced investors sometimes use a core-satellite strategy to customise their investment.

  • Core: A broadly diversified basic investment, which makes up the majority of the portfolio
  • Satellites: ETFs with a special investment focus are added (around the core) with a lower weighting

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.

• 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.
• Synthetically replication
  • Do not invest directly in the securities contained in the index, but enter into an exchange transaction (“swap”) with a large investment bank.
    • 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.
• hybrid replication
  • A combination of physical and synthetical replications
  • ETFs with physical and synthetic replication are selected in order to combine the advantages of both in the best possible way. (This is the case for the Scalable MSCI AC World Xtrackers (Acc).)

Comparison

• Distributing ETFs (Dist)
  • Dividends are paid out to your cash account at regular intervals (annually, semi-annually, quarterly or even monthly)
  • Often marked with a “Dist” or “D”
• Accumulating ETFs (Acc)
  • 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.
  • Usually marked with an “Acc” or “C” in the name

Total Expense Ratio (TER): The ongoing annual cost, 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

  • 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.

• Deducted directly from the fund assets and is already included in the market prices.

Tracking difference: The performance of an ETF may deviate (slightly) from the performance of its index due to the ongoing costs, taxes at the fund level, and the imperfect replication of the index. It is measured over a certain time interval and is shown on the issuer’s website or in the ETF’s factsheet.

• 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.

• Refers to the country in which the fund is launched.
• Many ETFs are domiciled in Luxembourg (because of its favourable financial legislation) or Ireland (because of 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.

• Allow investors to invest in an entire market segment with a single investment.
• The selection of individual securities as in active fund management is dispensed with. -> 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.)

• It is possible to invest in numerous securities at the same time.
• 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.

• The issuer takes care of the regular rebalancing of the securities within the ETF. -> An active adjustment of one’s own investment is not necessary.
• Regular rebalancing ensures that the components of a (physical) ETF always correspond to the underlying index and thus to the relevant market.

• 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.