Investing in ETFs: Is it worthwhile for investors to get started?

ETF stands for “Exchange-Traded Fund” and refers to exchange-traded funds that replicate an index. The special feature of this investment is the cost-effective, broad diversification of the invested capital. For this reason and due to their simple structure and transparency, they are becoming increasingly popular. Private investors also like to invest in such products in times of low interest rates. ETF′s offer an attractive opportunity to invest your money in the stock market in a diversified manner with manageable capital.

What exactly are ETF′s and how does the principle of passive investing work with ETF′s?

ETF′s pursue a passive approach and exactly replicate the performance of a benchmark index such as the SMI or the Dow Jones. The return of an ETF depends directly on the performance of the respective index. There is no active management, which keeps the costs for investors low. With regard to the replication of the index, a distinction is made between physically and synthetically replicated ETFs.

Key points at a glance:

• Passive approach: ETF′s are based on the performance of a benchmark index.
• Cost structure: The absence of active management results in lower fees.
• Yield dependency: The performance of the ETF directly follows that of the underlying index.
• Cost-effective: As an investor, you incur low management costs compared to actively managed funds.
• Replication types: There are physically and synthetically replicated ETF′s.

Incidentally, passive ETFs account for around 99% of all ETFs on offer, while actively managed ETFs are a marginal phenomenon. We therefore focus our comments on passively managed ETFs.

Physically replicated ETF′s

In the case of physically replicated ETF′s, the provider invests directly in the actual securities of the index. The weighting of the shares included corresponds exactly to that of the benchmark index. For example, if a share accounts for five percent of the market capitalization of the SMI, it is also represented in the “SMI” ETF with five percent. There is therefore an exact replication, which is constantly adjusted depending on the market situation.

The MSCI World global share index is very popular with investors. This contains around 1,400 shares of the world’s largest companies. However, it would be very difficult to replicate this number one-to-one in an ETF and would require a large amount of capital. This is why sampling is often used in such situations. Only those shares that have the greatest influence on index performance are taken into account. Stocks that have only a minor influence on the index are not included. However, it should be noted that the ETF then no longer reflects the benchmark index one-to-one. The ETF performance could therefore differ from the performance of the benchmark index.

Physically replicated ETF′s in a nutshell:

• Direct investment in the index components
• Accurate mapping of the index through constant adjustment
• Large indices such as the MSCI World are based on sampling (selection of the most important stocks).
• Sampling may cause slight deviations from the index development.

Synthetically replicated ETF′s

Synthetically replicated ETFs achieve the index performance via swaps with financial institutions. A synthetic ETF is therefore often referred to as a swap ETF.

For these swaps, the ETF provider concludes a contract with a financial institution, the so-called swap partner.

Under this agreement, the swap partner undertakes to pay the index yield including dividends. In return, he receives a fee – the swap fee – as well as the return on the securities included in the portfolio. What kind of portfolio? ETF investors’ money is invested in a portfolio of securities that serves as collateral in the swap transaction. The securities in the collateral portfolio do not necessarily have to match the securities in the benchmark index being tracked. For example, a synthetic ETF on European shares (MSCI Europe) can also contain American shares in the collateral portfolio.

A synthetic ETF is dependent on the swap partner fulfilling its obligation. If it can no longer make the payments, the ETF provider is forced to fall back on the collateral portfolio and possibly realize losses for the investors. Synthetic ETF′s are therefore subject to a so-called counterparty risk.

Synthetically replicated ETF′s in a nutshell:

• Investment in a collateral portfolio (not identical to the index).
• Swap partner guarantees the index return including dividends.
• Risk: If the swap partner defaults, losses could be incurred.

What are the advantages of investing money in ETF′s?

ETF′s impress with their low costs, high flexibility and broad diversification, which makes them very popular with investors. The cost efficiency of ETF′s is due to the passive approach.

However, they are not only a comparatively inexpensive, but also a very flexible investment solution, as they are always traded at the current market value. This makes investing in ETF′s a very transparent undertaking. You can always track the composition using the corresponding benchmark index. The broad portfolio that ETF′s generally represent ensures that you are sufficiently diversified and thus avoid security-specific risks.

And you have another advantage in terms of security: the legal status of a separate asset. This means that your units are treated separately from the assets of the fund company (ETF provider). So if the fund company becomes insolvent, your units will not be affected.

Last but not least, the ETF′s impress with their broad offering. This ranges from country indices to various sector, commodity or thematic indices such as hydrogen. You are spoiled for choice.

Advantages at a glance:

• Cost structure: Low management fees due to elimination of active management.
• Transparency: constant traceability of the composition.
• Diversification: Reduction of security-specific risks.
• Security: Units are considered special assets and are protected in the event of provider insolvency.
• Diversity: Investment possible in country, sector, commodity and theme indices.

What are the risks and disadvantages of passive ETF investing?

ETF′s require active portfolio management by the investor and involve risks such as currency influences. This investment product is a passive investment instrument. The ETF merely tracks a benchmark index. There is therefore no active risk management.

In addition, you often have a foreign currency risk, similar to investing in foreign shares. As an investor, you need to be aware of this. A negative currency development can reduce your return or eat it up completely. To avoid this risk, it is better to choose currency-hedged ETFs.

Even if you have opted for physically replicated ETF′s, you will not receive the underlying securities immediately. If the ETF provider goes out of business, which is admittedly very unlikely, you will have to be patient. It may well take several years before you finally get your securities. And who knows how they will perform in the meantime.

At a glance:

• Lack of active management: no protection against market risks, personal responsibility required.
• Foreign currency risk: exchange rate losses possible with unhedged ETF′s.
• Liquidity risk: If the provider defaults, it may take time to recover the invested assets.

How do experts rate the use of ETF′s in portfolios?

At Point Capital, we see ETF′s as a cost-effective, flexible instrument for covering a wide range of investment themes. They can be used to cover a wide range of investment themes, even with little capital investment. However, it is important to note that you as an investor must actively manage the ETFs yourself.

At Point Capital, we also rely on ETFs, especially for the tactical allocation of our investment portfolio. This enables us to react immediately to changes in the market in an efficient yet cost-effective manner and thus achieve attractive long-term returns for our clients.

How do we do that? We would be happy to show you in a personal meeting how we invest your money profitably in the long term and how we use ETF′s to do so. We look forward to hearing from you.