Transparency, low costs, risk diversification – ETFs offer many advantages over other forms of investment, but they also have disadvantages and entail risks. And only very few ETFs are suitable for asset accumulation and retirement provision. Read here what is important for your product selection.
What is an ETF?
ETF stands for “Exchange-Traded Fund”. Translated, it means exchange-traded fund. This is a special variant of mutual funds or funds.
With all funds, whether conventional or also funds known as ETFs, many investors pay into a common investment pot. The money is then invested according to the investment strategy of the prospectus. A distinction is made between different funds according to the type of investment (asset class):
- Bond funds,
- real estate funds,
- equity funds, and
- mixed forms.
A distinction is also made between active and passive fund management. In active fund management, the fund manager tries to generate above-average returns by making targeted investment decisions, for example by selecting individual stocks or buying and selling at specific times. These are conventional funds.
With passive fund management, the costs of fund management are much lower because the aim is to achieve average performance, measured against an index. Funds with passive fund management are also known as ETFs.
Although the term ETF (Exchange-Traded Fund) simply means exchange-traded fund, it always refers to exchange-traded index funds. ETFs are funds that track a specific stock market index, such as the DAX (or the MSCI World), and whose fund units are traded on the stock market like individual shares.
In addition to stock indices, ETFs can also track a bond index such as the REXP. The REXP measures the investment performance of German government bonds, which is made up of the change in price and interest rates. For you as an investor:in, this means that your ETF share performs pretty much like the index it tracks. Less the costs, of course, which arise with index funds in the form of transaction costs and management fees.
What are some important advantages of ETFs?
The costs are lower
The biggest advantage of ETFs over actively managed mutual funds is also the most important: ETFs simply cost less. Annual management fees for traditional actively managed funds are typically 1.5 to 2 percent of fund assets. ETF fees, on the other hand, are usually between 0 and 0.8 percent of fund assets.
You can purchase funds in two ways. Either directly from the fund company or through an exchange.
If you instruct your bank or an independent fund broker to purchase a fund directly from the fund company, an issue surcharge is usually due for actively managed funds. You must pay this to the fund company at the time of purchase. It can amount to 5 percent of the investment sum or even more. The fund company usually passes the issue surcharge on in full to its agents as a commission for the successful sale of the product.
If you decide to buy the ETF through an exchange, you usually only have to pay the order fees shown in your bank’s price list. Depending on which execution venue you choose (e.g. Frankfurt Stock Exchange, Xetra or direct trading), the fees may be lower or slightly higher. The costs for purchases via the stock exchange are regularly lower than the issue surcharge.
You remain more liquid
ETFs are easier to sell than conventional investment funds – in other words, easier to turn into cash. That’s because ETFs are traded on the stock exchange – and unlike conventional funds, not just once a day. Conventional mutual funds, on the other hand, you usually return to the fund company when you sell. Good to know: You can only do this once a day. And in order not to miss the return date, the order must be submitted by a certain time in the morning. You can still sell ETFs in the afternoon. In both cases, the account is credited two banking days later.
ETFs are safe
Just like conventional investment funds, ETFs enjoy the legal status of special assets. This means that your shares are kept separate from the assets of the fund company. If the bank where you keep the securities account or the fund company managing your fund should become insolvent, your ETF shares will not be affected.
The situation is different, for example, with index certificates or so-called ETCs (Exchange-Traded Commodities), which track the performance of commodities. These are legally debt instruments issued by the issuers and are therefore not protected in the event of bankruptcy.
What about transparency?
In the case of ETFs that track a well-known index, you can access information about the composition of the index on the Internet at any time. The fund companies usually even provide daily information on the exact composition of the fund’s portfolio. With conventional funds, on the other hand, usually only the 10 largest positions in the portfolio are available on a monthly basis.
What about risk diversification?
Even actively managed funds are legally required to reduce investment risk by investing in relatively many different securities. With ETFs, however, risk diversification is even greater. Prerequisite: You select an ETF that tracks an index that contains many securities. While an ETF on the Euro Stoxx 50 only tracks the performance of all 50 stocks contained in the index, an ETF on the American S&P 500 index contains 500 stocks.
And if you buy an MSCI All Country-World or an FTSE All-World ETF, you get the performance of around 3,000 to 4,000 stocks from around the world. You practically can’t achieve such broad risk diversification by buying individual stocks. What’s more, it would be associated with much higher costs.
ETFs as savings plans
You can also save something in ETFs on a regular basis. ETF savings plans are currently offered primarily by direct banks and occasionally by fund brokers on the Internet. Branch banks rarely offer savings plans with ETFs.
If you want to know exactly: Look for the “List of Prices and Services” on your bank’s website. You will usually come across a PDF document. Search this for the search term “ETF” and also look in the document for the purchase charges that would apply at your bank.
For smaller monthly payments, pay attention to how the buying and selling charges are calculated. In the price lists of the institutions they are usually called commissions, order or transaction costs. If there is a fixed fee in euros in addition to the percentage fee, it makes more economic sense to agree on higher quarterly or semi-annual savings installments instead of small monthly installments.
This way you can reduce commissions or order costs. Instead of e.g. 100 Euro monthly you can save 300 Euro quarterly. Most banks offer such payment intervals. You can interrupt or cancel the savings plans at any time free of charge, so they can be handled very flexibly.
What are the disadvantages and risks of ETFs?
ETFs are not the right product for every need. Moreover, very few of them are suitable for asset accumulation: Many ETFs do not pursue a favorable, broadly diversified investment strategy, but focus on specific sectors or themes. You should therefore inform yourself well before buying an ETF and carefully weigh up the selection criteria.
Expect price fluctuations
The same risks apply to equity ETFs as to conventional equity funds. You must always expect fluctuations in value. Even with global diversification, there have been price declines of up to 50 percent. It is true that prices have risen again after every crash, but in the past a loss phase could last up to 15 years. ETFs are therefore unsuitable for anyone planning to make major purchases or buy real estate in the near future.
Beware of theme ETFs
Fund companies are constantly launching new ETFs, depending on which topics are currently on everyone’s lips. This ranges from crypto ETFs to clean energy to rare earth ETFs or private equity ETFs. Companies like Stoxxs, for example, sometimes even invent new indices in order to launch ETFs that track their performance. These ETFs do not offer you a solid investment strategy. At best, they are used for speculation.
If you want to build up assets, select only those ETFs that are based on large, market-wide indices that include as many stocks from many countries and many different industries as possible. For example, the MSCI World Index includes about 1,500 companies from about two dozen developed countries. The MSCI All Country World Index and the FTSE All-World Index also include companies from emerging markets. ETFs on these indices are suitable as the basis for a diversified long-term investment strategy.
Counterparty risk – if a counterparty goes bust
It is occasionally claimed that ETFs carry a particular risk when they use swaps. Swaps are barter transactions between the fund company and banks. They are intended to ensure that the performance of the ETF exactly matches that of the index.
Swaps characterize so-called synthetic ETFs, but are also common in many conventional funds. In the ETF annual report, you will find so-called OTC derivatives in addition to swap receivables in the statement of assets and liabilities. OTC means “over the counter”, i.e. transactions outside regulated exchange trading. This also entails risks. The same applies if securities from the fund assets are lent to third parties.
In all these cases, we speak of counterparty risk. This means the risk of bankruptcy of a contractual partner, usually an investment bank, which is involved in the implementation of the investment strategy. On closer inspection, this risk does not apply specifically to ETFs, but to all funds. And the risk is secured from a regulatory point of view by the European rules regulating investment funds (UCITS).
As a result, any counterparty risk, whether due to securities lending or swap transactions, must not exceed ten percent of the fund’s assets. In addition, collateral must be provided.
In addition, the various ETF providers take precautions to mitigate counterparty risk. For example, swap counterparties are sometimes required to post collateral for their obligations that exceeds the actual value of the swap. However, these so-called collateral obligations, known in technical jargon as “collateral agreements,” are not included in the sales prospectuses. Investors can therefore not rely on these promises.
Attention sales trick ETF – here caution is appropriate
Insurance agents, so-called independent financial advisors and even fee-based advisors are increasingly using ETFs to sell investments and retirement contracts that do not meet their needs, are too expensive, too risky or inflexible.
Beware of the following scams:
“Net policy” from fee-based intermediaries: here, thousands of euros are sometimes collected for the brokerage of a unit-linked pension insurance policy in which the premiums are invested in ETFs. Separate brokerage agreements or fee agreements are offered for this purpose, which are supposed to obligate you to pay these fees, regardless of whether you pay the premiums in the future or not. In addition, a tax advantage is touted, but on closer inspection it does not exist. Especially not when you consider the fees, which are much higher compared to a simple ETF savings plan.
“Index policies” from the insurance intermediary: Here, indices specially created by insurers are used, sometimes with questionable investment strategies. But then it is not a broadly diversified investment based on a sound investment strategy. Through new indices, providers evade comparability and collect higher commissions or margins.
ETF asset management: Here, asset managers collect fees of around 1.5 percent per year. They are so high that they eat up all the cost advantages of the ETFs. However, you should not expect an above-average return, on the contrary. The managers buy and sell ETFs as they see fit, but deliver no added value – except to give you the feeling that someone is looking after your money.
Here’s what consumer watchdogs advise
ETFs are clearly the better alternative to actively managed funds, provided they track a broadly diversified index.
Before deciding to buy, also be aware of the disadvantages and risks outlined above. Therefore, only invest according to your own risk tolerance. Inform yourself beforehand about returns and risks in the past with our return calculator.