What an ETF is
An ETF is a fund traded on the stock exchange that simply copies a whole market. With a single purchase you own small stakes in hundreds or thousands of companies.
Learning objective: After this lesson you can explain how an ETF gives you stakes in many companies with a single purchase.
Instead of guessing which company will win, with an ETF you simply buy them all. An ETF on a broad world index holds more than a thousand companies from many countries.
Diversification
The first advantage is spreading. If one company goes bust, you barely notice, because there are hundreds of others in your basket. Losing everything that way is practically ruled out.
Low costs
The second advantage is cost. An ETF doesn't need anyone to pick stocks. It buys what's in the index. That's why it often costs only 0.1 to 0.3 percent a year, while a traditional fund charges more like 1.5 percent. With €10,000 invested that's €20 instead of €150 a year.
Not a safe product
An ETF still isn't safe. If the whole stock market falls forty percent, your ETF falls roughly as much. It takes away the risk of the single company, but the risk of the whole market stays. If you don't know that beforehand, the first big decline can easily feel like fraud.
Legally an ETF is a segregated fund. The money is kept separate from the fund company's own assets. If the provider goes bust, your stake is safe. The index is copied in one of two ways. A physical ETF really buys the shares, all of them or a well chosen selection. A synthetic ETF signs a swap contract with a bank that pays it the index return. That often tracks the index more closely but brings a collateralised counterparty risk.
Three figures to compare
Three numbers help you compare. Ongoing charges show what the fund costs per year. More telling is the tracking difference. It shows how far the fund actually lagged the index and also includes income from lending out shares and tax effects. The third number is fund size. Small funds get closed or merged more often.
Distributing or accumulating
There are also distributing and accumulating ETFs. Accumulating ones reinvest dividends automatically, so compounding works without you doing anything. Tax treatment differs from country to country. Most indices weight companies by market value, so big companies automatically carry more weight. That's intended. But it can mean a handful of giants make up a large part of your ETF, as is the case today with the big American tech companies.
Summary
- An ETF spreads across many companies and takes away the risk of the single company.
- The risk of the whole market stays, you go through every decline in full.
- Tracking difference tells you more than ongoing charges alone.
- Common mistake: buying several ETFs that hold almost the same companies and calling it diversification.
Did you get it?
Which risk does a broad ETF take away and which not?
It takes away the risk of individual companies, but not the risk of the whole market.
What happens to your ETF if the provider goes bust?
Nothing. An ETF is a segregated fund and isn't part of the fund company's assets.
Why does tracking difference tell you more than ongoing charges?
Because it shows how far the fund actually lagged the index, including securities lending income and tax effects.
What others often ask about this
MSCI World or FTSE All World, which is better?
The MSCI World holds stocks from about two dozen developed countries. The FTSE All World adds emerging markets such as China and India. Both are broadly diversified. Getting started and sticking with it matters more than choosing between them.
Is a single ETF enough?
For many people, yes. A broad world ETF holds thousands of companies. More ETFs don't automatically make a portfolio safer, and they often overlap heavily.
Check your understanding
Your task
You invest $25,000. Calculate the yearly cost for an ETF at 0.2 percent and for a traditional fund at 1.5 percent. Then enter $25,000 starting capital, a $0 monthly contribution, 7 percent return before costs and a 20 year horizon in the fee calculator and note the difference.
Sources and further reading
- Under Section 92 of the German Investment Code (KAGB), a fund's assets must be held separately from the management company's own assets and therefore do not fall into its insolvency estate. View source ↗