ETFs, short for Exchange Traded Funds, have become increasingly popular in recent years. While institutional investors have long since discovered index funds for themselves, many private investors are only just beginning to enter the market. What makes ETFs so interesting and why it's also worthwhile for private investors to have one or more ETFs in their custody accounts.
The advantages of ETFs
ETFs: Efficient, transparent and flexible
The abbreviation ETF could also be written with the words efficiency, transparency and flexibility. For in these areas, ETFs offer a number of advantages over other financial products:
Efficiency: ETFs closely track the performance of the benchmark index, and are more cost-efficient than conventional funds due to the absence of active management. Annual management fees are also lower than those of managed funds. What's more, ETFs generally don't incur issue or redemption fees, but only the usual transaction charges for buying or selling on the stock exchange.
-Transparency: With iNAV, the price of an ETF unit is continuously calculated and published on the stock exchange, based primarily on the prices of the individual positions contained in the ETF. In addition, the fund company publishes a daily update of the ETF's components.
-Flexibility: ETFs can be traded continuously during stock exchange opening hours. Market makers ensure that bid and ask prices are quoted at all times. What's more, a wide range of investment strategies can be pursued with ETFs: they are suitable for both short-term and long-term investments, and with ETFs it is possible to cover a broad market or invest specifically in promising sectors and regions.
Solid and sturdy
In addition to their efficiency, transparency and flexibility, ETFs also offer investors a high degree of solidity. The capital invested is protected as a special asset in the event of the fund company's insolvency, so investors do not suffer a total loss in this case. There is therefore no issuer risk, as with certificates or bonds, for example. What's more, ETFs are strictly controlled by national and European supervisory authorities, offering a solid, regulated framework for investing money.
Consequences of indexing
When it comes to ETF performance, investors can also be sure of one thing: the ETF cannot, in principle, underperform its underlying index. Whereas actively managed funds can meet, miss or exceed the benchmark, ETFs perform similarly to the benchmark – minus the ETF's management fees. On the one hand, this is an advantage, since investors are protected from a fund manager's bad decisions. On the other hand, it can also be a disadvantage, since they can't take advantage of good fund managers and can't beat the index. Indeed, even when markets fall, the ETF still tracks the underlying index. No reallocation can be made to mitigate the loss in value.
General capital market risks
In addition, ETFs present other risks that they share with almost all types of securities:
– Exchange rate risk for ETFs with securities from another currency zone: fluctuations in the corresponding exchange rates lead to fluctuations in the value of the corresponding ETF unit. Exists with all foreign currency investments. Investors can avoid currency risk by investing in a currency-hedged ETF. Currency risk is largely eliminated.
– Interest rate risk for ETFs investing in bonds : Changes in the level of market interest rates may cause changes in the value of the fixed-interest securities contained in the ETF.
– General market risk: Price fluctuations resulting from general market trends triggered by general economic factors may influence the value of the ETF.
Risk due to high correlation in the case of sector ETFs: In the case of a pure sector ETF containing only automakers, for example, sector crises directly lead to a loss in the ETF's value due to the correlation of the stocks contained in the ETF, as no stocks from other sectors are included that could offset losses.
Swap transaction risks
In this synthetic replication, index replication is mainly based on swaps. A swap is an exchange transaction between an ETF provider and a swap counterparty. Since large international banks can often replicate an index efficiently, the ETF provider can obtain the required performance from them via a swap. In detail, synthetic replication works as follows: The ETF invests in a basket of securities and exchanges its performance with the swap counterparty for the required performance of the benchmark index. The counterparty risk, or the market value of the swap (= difference between the value of the basket of securities held by the ETF and that of the benchmark index) is limited by legal regulation to 0% of the fund's assets. Since March 1, 2017, security rules have been further tightened. The European Market Infrastructure Regulation ("EMIR") requires risk mitigation procedures to be put in place for swap agreements. This regulation requires both parties to a swap transaction to exchange collateral in order to reduce counterparty risk to zero.
ETF applications
ETFs are versatile and can be used for saving, trading and as an alternative to derivatives. Above all, their low cost, high liquidity and the number of markets they can cover make ETFs a versatile investment instrument.
Because of their characteristics, ETFs are versatile. They are a particularly attractive investment instrument if savings plans are used to secure the future, but they are also suitable for shorter-term investment strategies and are therefore also used in trading and as an alternative to derivatives.
Savings plan
ETFs on broad-market equity indices are particularly suitable for long-term investment and asset accumulation through a savings plan. Transaction costs, unavoidable in regular savings, are particularly low with ETFs and, like management fees, are lower than the costs of saving in conventional funds. This makes ETFs particularly attractive to private investors, since lower costs in a savings plan ultimately guarantee a higher net return.
Trade
Low fees and high liquidity make ETFs particularly attractive to traders. ETFs can be traded just as easily as equities, but they cover the whole market, so it is possible to react optimally to short-term movements in an entire market. At the same time, the trader does not incur the transaction costs he would have to bear for the purchase of individual securities on the traded market. He pays only the low ETF fees.
Since ETF prices are calculated and published continuously, index funds are also suitable for short-term day trading. The trader knows the price of his ETF at all times, and can sell it quickly thanks to the high liquidity, or buy additional units. This would not be possible with comparable funds.
Alternative derivatives
ETFs are also often invested in as an alternative to index futures. Indeed, they can also be used to trade the performance of an index, but compared with futures or forward contracts, ETFs are subject to far fewer access restrictions and offer several other advantages. For example, unlike futures, ETFs have no maturity restrictions. Whereas with futures, investors have to transfer their investment to a longer-term contract towards the end of the term, and pay a fee for doing so, with ETFs, an index can be tracked continuously, and money can be saved in the process. Unlike futures contracts, ETFs do not require a margin deposit. Likewise, ETFs have no minimum contract size, making it possible to trade an index in smaller, more flexible denominations than would be possible with futures contracts. Their liquidity and sheer volume also make ETFs an attractive alternative to futures. Indeed, there are many more ETFs than index futures, and ETFs are a particularly attractive alternative for markets where futures are not available.
ETF replication types
There are also important differences in the type of index replication, which is the main objective of any ETF. Broadly speaking, ETFs can be divided into two categories in this area, namely direct replication ETFs and indirect replication ETFs. Direct replication ETFs replicate the index by buying the securities it contains, while indirect replication ETFs rely on swaps1 with banks to replicate the index.
Direct replication: what you see is what you get
The direct replication method is also known as physical replication. In this type of index replication, the ETF buys the securities contained in the index in exactly the same proportion as they are weighted in the index. As a result, the ETF holds a basket of securities whose performance is as close as possible to that of the benchmark index. If all the securities in the index are actually purchased, this is full replication. If only the highest-weighted members of the index are purchased, and stocks with very low weightings or, for example, lower liquidity are neglected, this is known as a representative sampling strategy. In this case, too, the basket of stocks evolves almost exactly in line with the benchmark index, since its performance is hardly influenced by the smaller index members.
However, this strategy has the disadvantage of incurring transaction costs every time the index changes, due to the purchase and reallocation of securities. As a result, direct replication is not the most cost-effective replication method. Transaction costs can also cause ETF performance to diverge from that of the benchmark. To avoid this and move closer to the goal of accurate, cost-effective index replication, many direct-replication ETFs engage in securities lending transactions. While this generates additional income, it also creates counterparty risk. This occurs if the partner in the lending operation becomes insolvent.
