ETFs for beginners

ETFs for beginners

ETFs are the absolute favorite instruments for many investors in the stock markets. Not surprisingly: interest rates on savings accounts have dropped to virtually zero and ETFs are a safe and inexpensive alternative. But although ETF is one of the most common abbreviations in the financial world, it does scare away many people unfamiliar with investment products. ETF stands for Exchange Traded Fund and suggests anything but a simple investment product. That is misleading however; ETFs are rather simple and basic trading instruments. Whether it is the Dax, the Dow Jones, or the S&P, ETFs allow investors to buy any stock market index you want.

The basic principle of ETFs

The basic principle of any index fund (ETF) is very simple. An index fund simply mimics the performance of a stock market index. For example, if the S&P increases by three percent, the index fund will increase by three percent as well. And if the S&P loses three percent, the ETF will drop with the same amount.

Why are ETFs so popular?ETFs for beginners

Investors around the world expect to make lucrative returns with ETFs. The large confidence in index funds is based on one reason in particular: many studies, especially the work of Nobel laureate Eugene Fama, show that in the long term almost no fund manager performs better than a big stock market barometer such as the US Dow Jones or the German DAX. The logical conclusion to draw from this is: when almost no one manages to outperform the average stock market, why not buy the stock market as a whole? Especially as the purchase of an index fund (also called a tracker) is significantly cheaper than investing in a traditional mutual fund (fund managers often require quite a lucrative salary).

How to find the right index?

However simple the basic principle of the ETF may be, the harder it is to really choose a good index. Virtually every index also has an index fund that tracks the index: whether it’s the Brazilian Ibovespa, the Thai stock index MSCI or an index that tracks the value of Canadian government bonds, almost any investment product can be found in the form of an ETF. Private investors have several thousand ETFs to their disposal. How should they possibly choose the best option?

Global diversification reduces risks

For beginners it is recommended to choose familiar indices when they start: well-known stock indices like the Dax, the Dow Jones, and the European Euro Stoxx 50 have the advantage that they can easily be followed at any time in the newspaper, on television or on the Internet. For the same most investors opt to invest in stocks or indices from their own country. But even for beginners there are some alternatives: those who pursues a global diversification of its money, can choose to invest in the so-called MSCI World. This index consists of both shares of established countries like the United States and Germany, but also takes into account many emerging market equities. This combination reduces the risk of your portfolio.

Physical or synthetic?

Only selection the index itself is not enough however. In case of physical replication fund managers actually buy the underlying securities. In case of synthetic replication one does not actually hold the shares or bonds in the Index, but it resorts to a complicated financial product that simulates the index, also called a “swap”. Beginners are advised to opt for the safest and most transparent product, which is the physical replication of the underlying index.

The value development of ETFs

Each ETF is designed to exactly replicate the performance of the underlying index. In general, provides of ETFs get incredibly close. In some cases, however, there might be small deviations. To determine the size of these deviations, professionals have developed a special code, known as a tracking error. When a tracking error of zero, the performance of the ETF is exactly equal to that of the underlying index at any time. If there is a big difference (i.e., the tracking error is too large), the purchase is not recommended.

ETFs are a low-cost investment

Investors who like to buy and sell new index funds from time to time should also take a look at the trading costs. Unlike traditional mutual funds, ETFs just track the index and therefore require virtually no management costs(passive investing). Various brokers allow private investors to compose their own portfolio of index funds. Traditional mutual funds on the other hand, aim to do better than the market (active investing) and thus actively try to create the (in their eyes) most profitable portfolio of equities. It goes without saying that the selection and maintenance of the mutual fund is expensive. And it is the investor who pays.

The higher the costs, the lower the returns

Even though the differences in fees for providers of ETFs are just tenths of a percentage point most of the time, one should always choose the cheapest one as an investor. At least if the index funds in question are otherwise quite similar. Because regardless of the performance of the respective index, one thing is certain: the higher the costs, the lower the returns.

Warren Buffet on index funds

That even the most successful investors in the world believe in the opportunities of ETFs, is demonstrated by a statement of investor Warren Buffett. After his death, he said, his heirs should invest at least 90 percent of his assets in index funds. And we are talking about billions here. According to the American magazine “Forbes”, Warren Buffett is the fourth richest man in the world. Those still doubting Warren Buffett’s advice: the investment company of the billionaire reported a record profit over 2015 of over 24 billion dollars (!).