ETFs – The deal with exchange traded funds
On an exchange (link blog post exchange) you can invest your money not just in stock but also in funds. At the moment a special type of fund is quite the fashion, so-called ETFs. But what are these investment forms and why are they so popular?
ETFs (exchange traded funds) are just that: index funds that are traded on the exchange. So far, so good. However, for most people this explanation will only raise more questions. So let's start with the basics:
What are funds?
Investment funds give you a great benefit: you diversify your risk. A fund is a collection of different stocks, bonds, or real estate securities. Investments are always subject to fluctuations. For instance, if one stock in the fund loses value, this is not the end of the world since the other fund components can balance these losses.1 The decision of how a fund is put together is made by the so-called fund manager. He selects a combination of financial values which he believes will increase in value in the future. For this active type of fund management investors have to pay fund management fees. An index fund, as the name indicates, is special in that it only contains the stock of a certain index. There are index funds for all kinds of indexes in the world, for instance the DAX or the Dow Jones.2
And what is an ETF?
An ETF is generally an index fund that reflects the value development of the associated index. So if you invest in an ETF for the DAX, you participate in its development: if the DAX decreases by 0.5 %, the ETF also decreases by 0.5 %. Or if it increases by 1.5 %, the ETF also increases by 1.5 %.3
What is special about ETFs compared to regular index funds is that ETFs are traded at the exchange. So they can be bought and sold on the exchange at any time, just like stock. Classic mutual funds on the other hand are only traded once a day.4
What are the benefits of ETFs?
Because ETFs generally reflect an index, they are usually passively managed funds. In contrast to "classic" actively managed funds, in which the fund manager makes investment decisions in order to achieve a great performance, an ETF fund manager only has the job of reflecting the value development of an index as precisely as possible. The consequence: the fund management fees for ETFs are significantly smaller.
That ETFs are traded at the exchange represents another great benefit to the investor. They can be traded with much more frequency and thus also more flexible than regular funds. In addition, because the fund reflects the index, investors always know exactly in what they are invested. Lower costs, flexibility, and transparency are thus the most salient arguments that speak for ETFs.5
How can you invest in ETFs?
If you would like to invest in ETFs, you need a deposit at a bank or online broker. And then you would be spoilt for choice since there are a countless number of options. For instance, for ETFs you can choose between different investment classes such as stock, bonds, or real estate.6 In addition, there a distributing and accumulating ETFs. In the former the profits are paid out on an annual basis, while in the latter the obtained profits are automatically reinvested. Since the reinvestment does not draw additional fees, accumulating ETFs are often the better solution for a long-term investment strategy.7
All in all, ETFs sound like a sensible supplement for any investment portfolio. But be careful: Like with any other investment form, you should do your due diligence before investing and ideally get advice from an expert.