Introduction to ETFs

Development of the MSCI World Index (screenshot taken at https://www.msci.com/world on 02/212017)

ETF? What’s that?

The name is an abbreviation for Exchange Traded Fund. Interpreting literally, an ETF is a fund in which you can invest  in or sell at the stock exchange. This it’s a more liquid version of a fund, because there is an open market where you can trade your shares.

Despite its literal meaning, the term ETF usually refers to funds which try to follow a special stock index, like EuroStoxx-600, NASDAQ-100 or the German DAX.

This sounds more complicated and less transparent than it really is: The most intuitive implementation is the following:

Let’s say, the purely fictional Gummy-Bear-Bank wants to start an ETF mirroring the development of the DAX, that is the development of the 30 biggest German companies. They buy stocks of those 30 companies and offer you shares which will develop similar to the underlying index, because they own those stocks.

No you can invest in more companies with the same amount of money. Thus you can diversify your investment and distribute your risk: If one company screws up and their stock prices crash, there will be other stocks which do not crash.
This diversification comes at a cost, the TER (total expense ratio: yearly costs). The fund management has to keep up with changes of the indexes, document stuff etc., and the cost is the TER. For ETFs, TER is typically lower than 1% per year. You’ll find ETFs on the MSCI World (consisting of more than 1600 stocks) that have a TER of 0.3%. Therefore, the yearly costs of index ETFs are much lower than the costs for actively managed funds. In the first fund management simply replicates the index development while the latter fund management has to find and actively implement its strategy.

Why are they popular?

At the moment interest rates are very low thus it takes longer until compound interest and exponential growth kicks in. Existing alternatives with a guaranteed performance like the German “Riester-Rente” have to adapt their conditions and still raise fees for signing the contract.

Those are the key advantages:

  • low initial cost: only order fees/provisions for buying and selling shares
  • low annual cost: only the TER
  • liquidity/flexibility: you can adapt your investments to your current financial situation
  • meeting stock market performance: a large index ETF will have similar development as the world economy, because lots of companies are part of it.
  • risk diversification: If single stocks crash, you’re not going to notice it in your investment.Sometimes I wonder, if the current praising of ETFs might be exaggerated. I listened to podcast episodes, where ETFs were hyped like a Holy Grail of asset accumulation. ETFs are a cornerstone of my investment strategy, but I think it’s dangerous to focus on a single asset class. There are other asset classes which offer a reasonable performance. Don’t rely on other people’s advice, but invest in your most valuable asset: Your mind.

Additional Information

For more information on exchange traded funds (or financial literacy in general), I’m recommending the following (German) podcasts/blogs:

If you’re looking for information focussing more on other countries or simply in your language, I recommend google. There are probably some bloggers and some podcasters in your country or language, too!

Keep in mind, that I am not a professional when it comes to finances and investments. It’s completely your decision, how to act on the information I am offering here. Therefore it’s your responsibility and I’m not liable for any losses (or gains).

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