Finance

What are ETFs? | How ETFs work – simply explained

More and more people invest their money with index funds cheaply and without much risk on the stock market. Everything you should know about ETFs and what to look for when buying can be found here.

The call money account has had its day. If you want to invest your money profitably in times of low interest rates, you can hardly avoid investing in stocks. So-called exchange-traded index funds, or ETFs for short, are becoming increasingly popular

Thanks to their broad diversification across company shares in entire markets, these special equity funds promise, on the one hand, a relatively low risk for investors. On the other hand, they are Income, called yield, comparatively high because, unlike traditional equity funds, there are no expensive management fees.

But what exactly are ETFs? How do they work What are the risks of ETFs? And can they also provide for old age? We explain everything you should know about ETFs in our large overview.

What are ETFs?

ETFs are special Fundswho put your money mostly in Shares, i.e. company shares, invest. They are particularly recommended for those new to the stock market. As an investor, an ETF allows you to comfortably invest in stocks from entire markets or regions – without hiring a professional fund manager who charges high fees for his work.

What is an equity fund anyway?
An equity fund is a type of basket that contains many different company shares. If you, as an investor, buy shares in an equity fund, i.e. if you put money in the basket yourself, you benefit from the income generated by the equity fund.
Traditional equity funds are usually offered by banks, mutual funds or investment companies that raise money from savers and investors. Well-known fund companies are for example Blackrock and Fidelity (both USA), Union Investment or the DWS Group from Germany.

The abbreviation ETF stands for the English name “Exchange Traded Funds”, in German: exchange-traded index fund. What is meant is a special one Investment fundsthat uses a computer algorithm to replicate a securities index, usually a stock index. The German share index, for example, can do that (Dax), which contains the 30 most valuable German stock exchange groups.

If you buy a part of a DAX ETF, invest your money at the same time in the shares of all DAX companies, from Adidas to RWE and SAP to Delivery Hero. If the price of the Dax then rises, your ETF will also become more valuable, so that you will make a profit on a later sale.

ETFs are very cheap. This is because a computer algorithm decides the composition of the fund and not an expensive fund manager who “actively” controls the composition. That is why ETFs are also called “passive equity funds”.

At the same time, ETFs offer you, the investor, a very wide spread of your money over shares in various companies and markets. In this way, the risk of loss is significantly lower compared to buying individual stocks, as the price fluctuations of the fund’s stocks offset each other (see below).

That is why ETFs are the ideal investment, especially for people who do not deal in detail with stocks but still want to participate in the earnings of the stock market. This is especially true if you are interested in a long-term investment that you don’t need to worry about much. The following graphic shows how popular ETFs have become in recent years:


Source: Statista, Thomson Reuters, Lipper, Bloomberg, ETFGI

Why do ETFs have such strange names?

At first glance, the names of ETFs can be confusing. On the second, however, the rows of letters are not as complicated as they initially seem:

Basically, the name of an ETF is made up of the abbreviation of the share index that the ETF tracks and the name of the fund company that issues the ETF.

As a reading example, let’s take one of the best-known ETFs with a very wide spread over shares of around 2,700 companies from all over the world, the ETF “iShares MSCI ACWI”. This is an ETF that the Blackrock subsidiary iShares sells.

Of the Stock index, which this ETF tracks, is abbreviated to “MSCI ACWI”. MSCI stands for Morgan Stanley Personal-Financial.com International, a financial services provider that publishes various stock indices – including the “All Country World Index”, or ACWI for short.

In addition to iShares from the US, numerous other financial companies offer and Fund companies ETFs. The most important include Xtrackers (DWS Group, Germany), Lyxor (Paris Société Générale, one of the largest commercial banks in France) and HSBC (major British bank). An overview of the most important dealers:

ETF brandFund company
or bank
country
iSharesBlackRockUSA
VanguardVanguard GroupUSA
XtrackersDWS Group
(Deutsche Bank)
Germany
LyxorLyxor Asset Management
(Société Générale)
France
ComstageLyxor Asset Management
(Société Générale)
France
HSBCHSBCGreat Britain
FidelityFidelity InvestmentsUSA
AmundAmundi
(Société Générale and
Crédit Agricole)
France
Franklin / Franklin LibertyFranklin Templeton
Investments

USA

How exactly do ETFs work?

In contrast to conventional equity funds, which are “actively” controlled by an investment manager, a computer algorithm is used as “passive” funds in ETFs entire stock indices such as the German Dax one to one after.

Specifically, in the case of a Dax ETF, this means: a computer buys the individual shares of the 30 largest German listed companies and weights them as they are shown in the Dax. Shares in large stock corporations such as SAP or Telekom are therefore more significant than the Delivery Hero or RWE shares.

A distinction is made between two different types of ETFs. While at “physical” ETFs If the computer actually buys the shares, it acts in the event of one “synthetic” ETFs only with a bank that guarantees the share price development. This is why physical replicating ETFs are more popular with many investors.

  • Whether physical or synthetic – the following applies to you as an investor: If the value of the stock index on which your ETF is based increases, you benefit to the same extent. For example, if you have invested money in a Dax ETF and the Dax increases by three percent, the value of your ETF also increases by three percent.

However, the reverse is also true: if the majority of all stocks within an index lose value, the index price itself falls, and with it the value of the ETF that replicates it. However, this usually only applies for a short time. In the long term, price fluctuations will even out.

Historical data shows that the values ​​of large stock indices develop positively over a longer period of 15 to 20 years – so you can count on profits (see below). ETFs are therefore particularly suitable for long-term investment, for example if you want to invest money for your children or grandchildren. Compared to a savings account, the return, known as the return, from ETFs is many times higher.

ETF or individual stocks? What is the benefit of ETFs?

The advantage of ETFs compared to buying individual stocks is that you can easily diversify your capital across numerous stocks – and pay very little fees. This will reduce your risk of making losses.

In addition, you don’t have to constantly deal with developments in the stock market – the computer algorithm does that for you. This is why ETFs are particularly suitable for those new to the stock market.

ETFs also have several advantages compared to “actively” managed equity funds, which are also broadly diversified. The most important at a glance:

  • Low cost: Because ETFs have an algorithm that replicates a stock index, they are cheaper than conventional equity funds. After all, there is no need to pay a manager to look after the equity fund. ETFs usually incur costs of less than 0.3 percent of the investment amount per year. Actively managed funds sometimes charge up to five percent of the investment amount.
  • High yields: With a broad diversification, ETFs achieve at least the same, often even higher, long-term return than traditional, actively managed equity funds. This is because even experts rarely manage to make precise forecasts about future market developments – in order to generate better returns than the broad mass of investors.
  • More transparency: Another advantage of ETFs is that they are more transparent than conventional equity funds. Since an ETF tracks a certain index, you as an investor know at all times which stocks the fund contains. Actively managed funds are often less transparent, and investors often only find out with a time delay or on a specific date which stocks the fund is currently made up of.
  • Lots of flexibility: As an investor, you can trade ETF shares on the stock exchange just as easily as you can with individual shares – and thus react flexibly to changing market situations, for example if you want to change your investment strategy. This is not easy with units of actively managed equity funds, as they often have holding periods.

Do I also get a dividend with ETFs?

Yes, it is basically possible. However, it depends on whether you have shares in a “distributing” Dividend ETFs or purchase an “accumulating” ETF that immediately reinvestments the companies’ profit sharing.

In addition to the type of ETF – physical or synthetic – there is also the question of whether you want to receive small sums of money from your investment on a regular basis:

  • Distributing ETFs transfer the income from dividends directly to your account. Of the advantage: You have regular income and can decide how you want to reinvest your money. Of the disadvantage: You have to deal with new investment opportunities and pay order fees.
  • Accumulating ETFs invest the generated income straight away. Of the advantage: In the long term, you benefit more from the compound interest effect and save time and fees for reinvesting income. Of the disadvantage: You have no regular income from your ETF.

The decision in favor of one or the other ETF form also has an impact on the taxation the income. This does not apply to the amount of the tax burden, but the timing of the tax payment differs.

What are the best ETFs?

Which ETF is the best for you depends to a large extent on your individual risk tolerance – and on the price of the respective ETF. It also plays a role how much you want to deal with individual companies, markets and the stock exchange in everyday life. In addition to the Dax, there are many other stock indices. The number of ETFs is increasing continuously, as the following graphic shows:


Source: Statista, Thomson Reuters; Lipper; Bloomberg; ETFGI

Basically, if you spread your capital widely, you reduce the risk of making losses. This is why ETFs that track global stock indices are particularly popular.

One of the most famous is the MSCI World Index. It tracks the performance of the 1,600 largest company shares from 23 industrialized countries. ETFs that track this index are considered to be relatively low-risk. The financial service providers who issue ETFs on this index include iShares, Xtracker and Lyxor.

The index offers an even broader diversification MSCI All Country World, which contains shares in more than 2,700 of the largest public companies in the world. It thus covers almost the entire global economy, including many companies in emerging countries. ETFs that track this index are also considered to be low-risk.

There are also ETFs from certain industries

As an alternative to these ETFs, there are numerous ETFs that are based on indices that contain stocks of particularly sustainable companies. An example of such an index is the MSCI World SRI.

There are also ETFs that focus on individual industries, such as the most promising German tech companies. One example of such an ETF is the ComStage 1 TecDAX UCITS.

Basically: A potentially higher return always goes hand in hand with a higher risk. So before you invest, think about the maximum risk you want to take. As a beginner, you should rather buy shares in ETFs that are associated with a low risk. If you’re feeling uncomfortable, it’s better to forego some returns than to take on too high a risk.

What does an ETF cost?

Even if ETFs are significantly cheaper than shares in a classic equity fund – they are not free either. The costs of an ETF can be assessed using key figures. The most important one is the total expense ratio, abbreviated TER (English for “Total Expense Ratio”).

The total expense ratio includes all fees that are incurred annually as long as you hold the ETF share. These include administrative costs and VAT that the fund provider has to pay.

The total expense ratio of an MSCI World ETF, for example, is between 0.12 percent and 0.5 percent per year. This means that ETFs are significantly cheaper than actively managed funds. If you invest around 1,000 euros in an ETF with a total expense ratio of this amount, the costs per year amount to between 1.20 euros and 5 euros.

These amounts will be taken directly from the bank or your potential winnings to you Fund company deducted. The following table with a selection of well-known ETFs gives a sense of the costs:

ETFindexFee per year (TER)Use of the proceeds
Xtrackers DAX UCITS ETF 1CDax

0.09 percent

accumulating
Xtrackers Euro Stoxx 50 UCITS ETF 1DEuroStoxx500.09 percentpouring out
Xtrackers MSCI World UCITS ETF 1CMSCI World0.19 percent accumulating
iShares MDAX® UCITS ETF (DE)MDax0.51 percent accumulating

Source: Justetf.com (as of March 2020)

For comparison: With actively managed Investment funds the annual expense ratio is often more than 1.5 percent per year, sometimes even up to five percent. Annual fees would be more than 15 euros if you invested 1,000 euros in such a fund.

Where can I buy ETFs?

Basically, ETFs are traded on the stock exchange just like stocks. In order to buy ETFs on the stock exchange, you can search for the desired securities in your securities account and purchase them after selecting a trading venue, for example the Frankfurt Stock Exchange (see below). The price of the ETF share can vary depending on the trading venue.

Buying shares is usually cheaper than trading on the stock exchange with a so-called Direct trader. This means a special securities dealer who holds selected stocks and fund units in stock. In over-the-counter direct trading, ETFs are usually cheaper because, as a private investor, you save exchange fees. Common direct traders are, for example, Tradegate, Lang & Schwarz or Baader Bank.

How do I buy ETFs online?

Whether you are trading on the stock exchange or directly, you need a securities account to invest in an ETF. The easiest and cheapest way to open this is on the Internet – with a direct bank or an online broker.

The next steps are very easy: You can easily find the ETF shares you want using the search mask for your securities account. All you need is the securities identification number (WKN) or the international identification number (ISIN) of the security.

As soon as you have selected the relevant ETF, enter the order to buy: Only now will you decide whether you will buy the ETF on a stock exchange – or from a direct trader with whom your direct bank or online broker may cooperate (see below) .

How to secure your ETF share in three steps:

1. Open a depot: First of all, you have to open a deposit with a branch bank or with a direct bank on the Internet. The deposit with a direct bank is often free of charge.
2. Select ETF: Find out which ETF is suitable for you on comparison portals. In addition to the total expense ratio, keep an eye on the risk class. The following applies: the higher the risk, the greater the chance of making high profits – but also the likelihood of making losses.
3. Buy and maintain ETF: You can use the securities identification number (WKN) to find the ETF in your securities account and buy a share. It is advisable to only invest money in an ETF that you won’t need for 15 years or more. The longer you invest your money, the lower the risk of making losses. Because in the long term, short-term exchange rate fluctuations balance each other out.

The most important criterion when buying is the price: even if it only differs in the decimal places for each trading venue or direct trader, you should always choose the cheapest offer.

Tip: Buy and sell ETFs only from Monday to Friday between 9 a.m. and 5.30 p.m. when the Xetra electronic exchange is open. In this way you can compare whether the direct trader of your choice actually offers a cheaper price than trading on the stock exchange.

How do I set up a savings plan for ETFs?

With a ETF savings plan you regularly invest a certain sum in an ETF. It is very easy to set it up with a direct bank on the Internet or an online broker. In just a few steps, we will show you what is important:

  • Step 1: Create a depot. You can open this at a direct bank or an online broker. In contrast to branch banks, there are usually no fees for this. It is important: Compare the conditions of the online providers for your savings plans. It’s not just a matter of cost. It is also crucial which stocks or ETFs are available to you to save. With many providers you do not have the full choice, some only advertise with time-limited campaign savings plans, the costs of which increase later.
  • Step 2: Pick the ETFs you want to invest in. It is advisable to diversify your risks widely. ETFs that replicate the MSCI World or the MSCI All Country World are particularly suitable for this.
  • Step 3: Determine your ETF savings rate and the savings rhythm. You can usually choose between monthly, quarterly or half-yearly payments. As a rule, you can change the savings rate when you realize that you want to save more or less.
  • Step 4: Waiting. We recommend an investment period of ten to 15 years, as short-term price fluctuations usually cancel each other out during this time.

What return can an ETF investment bring?

How high the return of an ETF in the future cannot be said in general terms, as no one can predict future stock prices. In order to get an impression of the possible percentage returns of an ETF, it is worth taking a look at the past – for example on the price development of the MSCI World Index.

The average annual return of the MSCI World, which contains shares of around 1,600 companies from 23 industrialized nations, is around 9.2 percent for the years 1970 to 2015. Over the past ten years, the average annual return of the MSCI World has been 6.82 percent.

An example: If, in the past ten years, you had paid 100 euros a month with a savings plan into an ETF with an average annual return of 6.8 percent, you would now have an amount of around 17,000 euros. 12,000 euros of this would be your deposits, the income amounted to around 5,000 euros.

It is important to note that the previous performance of an ETF is an important indicator to see whether an ETF is growing rather strongly or moderately. But: This price development from the past is never a guarantee for future profit opportunities. Nevertheless, it serves as a good guide for a first look,

Risk: How Safe are ETFs?

How much risk an ETF entails largely depends on which one Stock index he reproduces. In general, it can be said: the more stocks from different industries or countries an index contains, i.e. the broader it is, the lower the risk is the ETF that tracks it.

As with conventional Equity funds or at Buy individual stocks Even with ETFs, there is always the risk that the prices on the stock exchange may fall for a short time, causing your ETF to lose value – for example in the event of a stock market crash. Since you diversify your capital widely with an ETF, ETFs are among the safest investments if you want to profit from stock market profits. The risk is much lower than, for example, when investing in individual stocks.

It is also unlikely that an ETF fund company will file for bankruptcy. If it does happen anyway, it doesn’t matter for you – because your money is protected as a so-called special fund and will not be touched by the insolvency administrator.

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