ETF – Invest Simply And Cheaply In Shares: With Index Funds

The most important facts in brief:

  • Index funds (ETFs, Exchange Traded Funds) allow you to build up assets with shares over the long term, simply and inexpensively.
  • ETFs replicate stock lists, so-called indices such as the Dax, S&P 500 or the global stock index MSCI World. With an ETF, you achieve the same return as the broad mass of equity investors.
  • ETFs are just as safe as actively managed funds: money you have invested in ETFs is special assets and protected in the event of bankruptcy of the ETF provider.

How to proceed:

  • Open an online securities account. A good solution for account, credit card and custody account is available from DKB, Comdirect, Consorsbank. You can trade particularly cheaply at Smartbroker, Onvista Bank and Trade Republic.
  • Either invest a larger amount in ETF units or save every month with an ETF savings plan.
  • To build up assets over the long term, invest in an ETF that automatically invests dividends for you (reinvested). In this way you benefit from the compound interest effect.
  • Finanztip recommends the following globally oriented ETFs: iShares (ISIN: IE00B4L5Y983), Source (ISIN: IE00B60SX394) and Xtrackers (ISIN: IE00BJ0KDQ92). The identification number is in brackets.

They are in vogue: exchange traded index funds, or in English “Exchange Traded Funds” or in short: ETFs. These are funds that track the performance of well-known stock market indices such as the Dax or S&P 500. More than 1,300 ETFs were available on the Frankfurt Stock Exchange Xetra alone in August 2018.

With ETFs, every private investor can take the investment into his own hands. An online custody account is all that is needed to participate simply and inexpensively in the stock market and build up long-term assets. Today, every seventh euro that Germans invest in funds is already invested in an ETF.

What are ETFs and how do they work?

An ETF is a replica of an exchange index: In the simplest case, an investment company takes the investors’ money and buys all the securities contained in the index. These are usually shares or bonds.

Take the German stock index Dax as an example: This index shows how much the 30 largest companies in Germany are worth. An ETF that tracks the Dax would now buy precisely these 30 shares – and then develop exactly the same value as the Dax.

Investors invest “in the market

A stock index often groups together those companies that are most valuable on the stock exchange – i.e. whose stock price multiplied by the number of shares gives the largest amount (market value). These are also the most popular companies among the broad mass of investors. It is therefore also referred to as a stock index “reflects the market”.

The objective of an ETF is to achieve exactly the return that the index achieves. An ETF does not try to be smarter and better than the broad mass of investors by selecting individual stocks. With an ETF you can participate in the market easily and cheaply, you follow the majority.

Which shares end up in the index is reviewed several times a year. If the composition of the index changes, the ETF also improves.

ETFs are unbeatably cheap

This strategy gives ETFs a major advantage: they cost significantly less than funds in which a fund manager selects shares individually (so-called active funds). Not only do you pay significantly less commission or none at all for the brokerage (purchase) of ETFs. In the best case, the running costs also only account for one seventh of the costs of active funds. This means that the ETF retains more of the actual performance from the outset.

Cost differences between active and passive funds

Various studies have shown that only very few actively managed funds manage to outperform the masses on a sustained basis, even after deducting all costs. This is one of the reasons why Finanztip exclusively recommends Exchange Traded Funds for equity investments.

If you would like to read in more detail about how the individual costs of ETFs are made up, please read on in the Costs section below.

Different types of ETFs

Index funds take different approaches to the task of replicating a stock index: There are two different types of ETFs. The way in which investors participate in company profits (dividends) can also differ.

Physical ETF – If an ETF simply repurchases the securities (shares) in the index, experts speak of a physically replicating ETF. They are generally very popular with investors because they are easy to understand and transparent: Investors always know exactly which securities they have just invested money in. It can also happen that an ETF does not actually buy all the shares, but only an optimised selection.

Synthetic ETF – Instead of buying shares individually, the ETF provider can have the desired performance guaranteed by a bank. In return, the bank receives a basket of known shares from the ETF provider. This exchange can be cheaper for both parties in the end.

Distributing ETF – If a company makes a profit, this is regularly distributed to shareholders as a so-called dividend. If shares are held in a fund, the dividends first flow to the fund. It can then pass on the distributions to the investors in a bundle. This reduces the value of the fund. Investors can use the dividends to pay taxes, for example.

Reinvesting ETF – An ETF also has the option of crediting the dividends to the fund assets. This is known as a reinvesting or accumulating ETF. Such ETFs are suitable for investors who want to build up assets over the long term. This is because the dividends also benefit from (positive) performance, similar to the compound interest effect.

If you would like to understand in more detail how physical and synthetic ETFs differ, read on below.

Which ETFs does Finanztip recommend?

Finanztip calculations have shown that investors who have invested any 15 years in a globally oriented equity index fund in the past have never lost money. This is due to the fact that such an ETF spreads the risk of loss over many shoulders and thus compensates for it.

We therefore recommend that you invest for the long term in an ETF that covers the global equity market and reinvests dividends. ETFs that track the following share indices are suitable.

MSCI World: This covers the 1,600 or so largest stocks in the industrialised world.
MSCI All Countries World: It covers more than 2,500 stocks from the industrialised world and emerging markets such as China, India and Brazil.
Sustainable Indices: Contains the shares of a global index that operate sustainably – i.e. pay particular attention to the environment, social standards and management.
In 2018 we analysed ETFs on these indices and can recommend six exchange traded funds from different providers. All ETFs reinvest dividends in the fund assets. Savers benefit from a kind of compound interest effect. The ETFs are suitable for long-term asset accumulation.

These ETFs recommend – Who is behind the ETFs

ETFs are usually issued by banks and special fund companies. In Europe, the largest ETFs are iShares, which belong to the US asset manager Blackrock. They are followed by ETFs under the Xtrackers brand, in which Deutsche Bank holds a majority stake via the fund company DWS, and ETFs under the Lyxor brand, which belongs to the French Société Générale.

The ETF brand Comstage, which originally belonged to Commerzbank, is well known in German-speaking countries. Société Générale acquired Comstage in autumn 2018. From mid-November 2019, the Comstage website will be redirected to Lyxor. The ETFs will probably be adjusted in the second quarter of 2020, meaning that Comstage ETFs will then trade under the Lyxor name. As things stand at present, however, the changeover has no disadvantages for savers. British ETF providers are SPDR (pronounced: spider) and Source.

Criteria for the ETF recommendation

The decisive factors for our recommendation were that the ETF has been available on the exchange for more than five years, that more than 100 million euros of investor money has been invested and that important investor information on the product is available in German.

An ETF needs to be a certain age in order to be able to check whether the ETF has actually matched the performance of the underlying index. A certain investment volume is necessary in order not to risk that the ETF provider takes the index fund off the market again because it is not worthwhile.

The running costs of an ETF are not a criterion for recommendation. This is because financial tip calculations over the past few years have shown that ETFs with lower running costs have not systematically generated more returns every year than more expensive ETFs.

For example, some ETFs lend some of their shares to other banks in the short term, which generates additional profit. Or they manage to get more withholding tax refunded. If in doubt, the higher costs are worth it.

In the end, what matters is that the ETF comes close to the performance of the so-called net index after costs. All the ETFs we recommend achieve this. The net index takes the value of all shares, deducts withholding taxes from it and adds dividends.

Where and how can you buy ETFs?

If you want to buy ETFs and then hold them in safekeeping, you do not need to go to a branch bank. You can save the fees that banks often charge for the securities account. Instead, open a free online custody account with a direct bank or securities dealer on the Internet (online broker).

We recommend either custody accounts where you can buy and sell ETFs at a very reasonable price or particularly convenient custody accounts. In May 2018, we filtered out the best of 15 free custody accounts.

Read more in the securities account guide

With the right securities account, you pay little for buying and selling equity funds (ETFs).
Financial tip recommendations: As a combination of a securities account, current account and credit card have performed best: DKB, Comdirect and Consorsbank. The cheapest providers are: Smartbroker, Onvista Bank and Trade Republic.

Ordering ETFs made easy

Once you have opened the portfolio and decided which stock index you would like to invest in, you are almost there. All you need to do now is enter the securities identification number (ISIN) or the identification number (WKN) in the search function of your securities account and follow a few simple steps. You will always find the number in brackets in our ETF recommendations.

We have compiled a detailed description of how to proceed in order to actually buy ETFs in the Buy Shares guide.

Time of exit decisive

Basically, you have the choice of investing a larger sum at once or, for example, saving monthly or quarterly in smaller instalments in an ETF savings plan. It is not so important when you start saving: The main thing is that you stay with it for the long term. What is more important, however, is the time of exit.

If you know, for example, that you will need your ETF savings in five years’ time, you should not trust that stock market prices will be high at that exact time. Instead, you should gradually reduce your ETF assets – i.e. sell ETF units – and park the money you release in a well-interest bearing overnight deposit account. We explain in more detail what this can look like in the Investment Guide.

More on this in the ETF Savings Plan Guide

Regularly invest small amounts in low-cost equity index funds (ETFs) and build up long-term assets.
Recommended providers: DKB, Comdirect, Consorsbank, Smartbroker, Onvista Bank, Trade Republic.

ETFs as the third component of investment

Finanztip recommends ETF saving as part of your investment alongside a good call deposit and time deposit. How much you invest depends on your budget and your perception of risk. If you would like to know more, you can take a look at the various sample portfolios we have calculated in the Investment Guide.

In the case of the yield-oriented portfolio, for example, we assume that savers park around 20 percent of their savings in a call money account in order to be liquid when urgent purchases are due. They invest the remaining 80 percent in globally oriented exchange-traded funds. In the past, such a portfolio has never made a loss over any 15 years.

How safe are ETFs?

Basically, the following applies to every fund and also to ETFs: money invested in fund units is special assets and protected. So you don’t have to worry: if your ETF provider goes bankrupt, your fund units will still belong to you.

In detail, the law requires fund companies to keep their clients’ money (their fund units) separate from the company’s assets. They usually deposit them with independent custodian banks. In the case of the ETF providers Xtrackers and iShares, for example, this is State Street Bank in Luxembourg and Ireland respectively, and in the case of the ETF provider Comstage it is BNP Paribas.

This prevents the investor’s assets from being included in the bankruptcy estate in the event of the fund company’s bankruptcy, which would result in creditors’ claims being satisfied. The custodian bank is then obliged to take over the management of the ETF – either permanently or until another ETF provider buys up the fund units.

If the custodian, rather than the fund company, is the insolvent custodian, the law requires fund units to be transferred to another trustee who will then act as the new custodian. Such an occurrence should not disadvantage you.

If your online bank or the broker with whom you hold your personal securities account should fail, there is also no reason to panic. A trustee would take over your securities account and serve as your new contact person.

Are physical ETFs safer than synthetic ones?

Many investors can better imagine that an ETF provider simply buys index shares (physically replicated) – and therefore consider this procedure to be safer. In contrast, stock swaps in synthetic funds are difficult to understand. Some people fear that if the ETF provider goes bankrupt, they will not get back the full value of the index.

In the end, the risk of losing money in the event of the insolvency of one party (ETF provider, bank as the exchange partner) is very low for both types of ETF – and very theoretical. In detail:

Example: Physical ETF – The ETF provider does not always buy all the shares included in the index. In the case of broadly diversified indices, such as the MSCI World, the ETF provider holds an optimized selection of shares that are sufficient to reflect the performance of the index sufficiently well (optimized sampling). At the same time, the ETF provider lends parts of its equity holdings to other market participants, such as securities traders or investment banks that need shares in the short term. In this way, the ETF earns a little extra and can generate more return for investors.

The securities lending itself is secured and strictly regulated. For example, a trader who borrows shares from the ETF provider has to deposit collateral, such as government bonds, in return. At the end of each trading day, a check is usually carried out to ensure that the value of the deposited government bonds still matches the value of the shares. If they are not, the securities dealer must add collateral. This is to ensure that the value of the ETF remains close to the index value at all times despite securities lending.

Example: Synthetic ETF – ETF provider A has swap partner Bank B guarantee the performance of the global share index MSCI World. In return, A builds up a so-called carrier portfolio with some well-known, frequently traded shares and assures this performance to Bank B. The partners regularly compensate for differences in performance. A problem could arise if Bank B became insolvent and could no longer deliver the performance of the MSCI World to ETF Provider A as agreed.

ETF Provider A would then have to resort to its own equity portfolio and cash in on it. If the equity basket were to be worth less than the MSCI World, Provider A would have to tap the collateral deposited by Bank B for this purpose – usually government bonds or cash holdings – and sell it. In Europe it is strictly regulated that differences in the value of the two portfolios, the so-called swap value, must always be secured. Since March 2017, this has even been 100 percent. The swap value is determined daily and collateral is drawn down.

The difference between physical and synthetic ETFs

Are ETFs riskier than active investment funds?

The more popular ETFs become, the more critical voices are heard. For example, the question often arises as to whether it is riskier to invest in ETFs than in traditional equity funds. Let me say it up front: If you invest in an ETF that does not track a niche market, but rather a well-known, large stock index, you have nothing to fear.

These are the main points of criticism and our response to them:

ETFs are using their market power to amplify the downturn

When investors withdraw money during a downturn, ETFs must sell shares. That’s right. But the same is true for actively managed funds. It is not so much the funds that are to blame for the fact that a downturn is intensifying, but rather the “pro-cyclical” behaviour of many investors to sell in panic. Hence the appeal: Stay calm and invest for the long term!

ETFs hold too little cash. In a downtrend phase you will not get rid of your shares.

ETFs usually hold less cash reserves than actively managed funds. However, it is unlikely that the special ETF dealers (market makers) appointed on behalf of the ETF fund company will not be able to take their ETF shares off investors. This could only happen if the ETF is invested in illiquid niche markets where hardly anyone trades. The ETF company would then not sell the shares deposited with the ETF on the market at all or only at very poor prices. If an ETF invests in the world’s largest stock indices, this is not to be feared.

ETFs on the MSCI World are risky because they are denominated in dollars

Some of the ETFs on the MSCI World, like the index itself, are denominated in US dollars. There is a currency risk against the Euro in the sense that a Euro investor may not be able to fully benefit from a positive performance of the Dollar ETF. He must always accept “markdowns” if the euro has appreciated in parallel with the (positive) performance of the index.

However, experience shows that over longer periods of time exchange rate changes do not play such a significant role. Investors should also attach importance to the broad diversification of investments. No index does this better than the MSCI World, which comprises 1,600 individual stocks from 23 countries. Our calculations show: Even a world stock index converted retrospectively into euros has increased its value by an average of a good 7 percent each year over the past 45 years.

In our blog post we have analysed further points of criticism of ETFs.

How are the costs of ETFs made up?

Investors who are more interested in the costs of ETFs can take a look at the so-called Total Expense Ratio (TER) in the securities prospectus or on the overview pages on the Internet. It expresses how many percentage points the costs reduce the annual return – and is therefore also called the total expense ratio or effective expense ratio.

The TER includes the ETF’s flat fees for administration, custodian bank and the production of investor information. VAT and other minor fees are also included. ETF providers estimate the TER and usually deduct it from the fund assets on a monthly or quarterly basis. For ETFs, the TER is usually between 0.1 and 0.5 percent per year.

The TER does not include transaction costs that the fund must pay when buying and selling securities. The actual costs of the ETF are therefore always slightly higher than the TER calculated for the previous financial year.

What do you have to bear in mind when it comes to tax?

Up to and including 2017, the exact way in which certain ETFs are taxed was still a criterion for selecting certain types of ETF. Sometimes it was necessary to painstakingly add information by hand to the tax return. Since 2018, things have become much easier.

The new Investment Taxation Act has been in force ever since. For the first time for the 2018 calendar year, all investment funds (mutual funds) will be subject to final withholding tax according to the same logic. It is no longer important in which country a fund is established and whether it distributes dividends or also accumulates them.

Using a specific formula, your custodian bank will calculate an annual assessment basis for the flat rate tax of a good 25 percent. The tax is withheld directly, unless you submit a corresponding exemption application to your custodian bank. Investment income is tax-exempt up to EUR 801 in the case of individually assessed assets and up to EUR 1,602 in the case of jointly assessed assets.


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