Exchange-traded funds, or ETFs, are funds traded on the stock market that very closely follow an index. We might say that they track the course of the index – they mirror it one for one. In other words, ETFs are funds (pots of money) that are traded on the stock market (just like stocks) and have the same value pattern as the index they track. One of these indexes could be the DAX, for example, which is formed by the 30 most important companies traded on the stock market in Germany today.
An ETF on a stock index thus constitutes a pretty simple way to share in the performance of the underlying index. But there are also other indexes, which track commodity prices, bonds, or part of the real estate market, to name a few.
How does it work?
With funds, the individual securities for the fund portfolio are selected by active management, whereas an ETF tracks the performance of a stock market barometer on a one-to-one basis. For instance, if the German stock index DAX wins (loses) 2%, the ETF on the DAX also wins (loses) 2%.
Most ETFs simply replicate the index they track. This makes them much cheaper to operate in comparison to actively managed funds. Those who buy stock in classic mutual funds are also always paying a fund manager. That’s the expert who is conducting research and analysis to decide in each individual case which securities the fund will buy and which it won’t. That makes it cheap to manage an ETF, so you as an investor pay relatively low fees. Classic investment funds usually have a sales load of 3 to 5% of the invested amount as a fee when purchased, plus an additional 2 to 3% annually for a management fee. The annual fees of an ETF usually sit around .05 to .5%. There is no sales load.
A major advantage of ETFs, then, are the low fees. In addition, actively managed mutual funds usually perform worse than comparable ETFs. In recent years, a large number of scientific studies have illuminated all facets, corners, and edges of the question of whether or not and how well an expert can successfully beat the market. Here’s the question: Does a brilliant fund manager always make such clever and visionary investment decisions that their fund outperforms the average market performance over the same time period?
The bottom line is that very few fund managers manage to beat the performance of the benchmark index over several years.
All these reasons are why ETFs lend themselves particularly well to long-term saving, for example for retirement. Under what’s known as an ETF savings plan, you put in money monthly to be invested in one or more ETFs.
How exactly do ETFs track their underlying indexes?
ETFs that fall under the umbrella of physical replication simply buy all of the securities that make up the index whose value it mirrors – so for example, all 30 stocks of the DAX. The 30 stocks are then – to use a metaphor to help illustrate – together in a pot of money (the ETF). If you buy this ETF on the DAX, you own a small piece of this pot of money. It takes on exactly the same value as the DAX – that is, the stock of the 30 companies that make up the DAX.
Alongside this are what are known as synthetically replicating ETFs. They don’t buy the stock of the index directly, rather they mirror its performance via derivatives. Derivative comes from the Latin verb derivare, which means to lead or to draw off. A derivative, then, is a financial product that has been drawn off, or derived.
We think so too.
Luckily, it’s pretty easy to explain. Think of a derivative as a contract between two people, the two people being contractual partners. This contract states that one of the two of them will sell to the other a certain thing for certain price at a certain time in the future. Example: Person A is going to sell a share of the company Best Female Finance App in the World to person B for 333 euros three months from today, down to the exact day. Person A and person B have made an arrangement today in signing the contract.
The third type of index replication is called sampling. With this type, the index does replicate the index physically, but it doesn’t invest in every one of the underlying securities of the index. Sampling is usually done by ETF providers who want their ETF to track an index that contains a large number of individual securities (for example, a large number of different stocks). Like the MSCI World index, which has more than 1600 constituents! If someone wanted to buy all of them, it would take a ton of time and administrative effort. Therefore, an ETF intended to track the MSCI World that uses the sampling method would select the largest and/or most important securities in terms of determining the performance of the index.
One last point for you to think about: There are accumulating and distributing ETFs. With accumulating funds, dividends and interest are automatically put back into the fund and invested; the value of the fund share increases. If you buy a distributing product, on the other hand, the profits are paid out to you. If you want to capitalize on the effect of compound interest, you should purchase an accumulating ETF.