What is an ETF in simple terms and how to choose a fund

Exchange-Traded Funds (ETF), or exchange-traded funds, are an important element of the modern investment world. But what is an ETF, and why are they attracting the attention of investors? In this article, we will examine the key aspects of ETFs, explain how they work, and why they have become a popular tool for portfolio diversification and achieving financial goals.

What is an ETF?

ETF — Exchange Traded Fund. To better understand what an ETF is, imagine the following picture:

Seven investors decided to chip in $100 each and buy 10 shares, because it would be TOO EXPENSIVE for each of them to buy those same 10 shares on their own. The group set up a fund, using money from a shared “pot” to buy these 10 shares, and then divided the fund equally amongst themselves. As a result, each investor became the owner of one unit, i.e. 1/7 of each share. This is precisely how an exchange-traded fund (ETF) works.

It is often said in financial circles that ETFs have “democratised” investing. Thanks to them, the stock market has become accessible to retail investors who do not have at their disposal of large sums for investing.

The history of the creation of ETFs

The idea of creating such an innovative exchange-traded product capable of reducing market volatility arose as far back as 1988 and belonged to Nathan Most, Vice-President of New Product Development at the American Stock Exchange (AMEX). True, due to bureaucratic delays, the Americans lost out to the Canadians in the initial implementation of this idea. Those guys turned out to be somewhat quicker and in 1990 issued the first official ETF, which tracked the Toronto Stock Exchange 35 Index.

Only three years later, in 1993, the famous SPY (or “spider” as we call it) – the first American S&P 500 ETF (SPDR S&P 500 ETF) – saw the light of day. Today, SPY is the most traded exchange-traded fund in the world, with hundreds of billions of dollars under its management.

ETF providers

Every exchange-traded fund, or ETF, is managed by a specific company called an “ETF provider”. One provider usually manages several or many funds.

There’s no such thing as a ‘good’ or ‘bad’ provider. It’s just that each one has its own particular features, such as fees, region, management style, and so on.

List of the world’s largest ETF providers:
iShares
Vanguard
Invesco
SPDR
Amundi
Xtrackers
WisdomTree

Important: If the issuer or ETF provider goes into administration, the investor will be able to assert their rights to the securities held in the fund’s portfolio.

Advantages of ETFs

ETFs have a number of advantages compared to other investment instruments:
1. ETFs help to minimise market risks through diversification. Thanks to the wide range of different shares and bonds held within an ETF (up to 4’000 shares), an investor’s portfolio will be less volatile and more resilient in times of crisis.
2. An ETF is a great way to “buy the whole market” in one go with a small investment and without the hassle of exhausting individual stock picking. It is an excellent tool for investors with a small initial capital. €100 is enough to buy your first ETF.
3. For people who are just starting out on their investment journey and trying to “get a feel for” the market, ETFs are more likely to deliver higher returns than individual shares.
4. ETFs are ideal for passive investing. It doesn’t take an investor much time to manage an investment portfolio based on ETFs. A couple of hours a year is enough.

How do you choose ETFs?

So, what criteria should be used to choose quality ETFs that will serve as the foundation for a balanced and resilient portfolio? Here is the full list:
1. The “Total Expense Ratio” (TER), also known as “Verwaltungsgebühren” in German, is a fund management fee expressed as a percentage of the fund’s assets under management. For example, if you invest €1,000 in ETF X, which has a TER of 0.2%, you will pay the provider of this ETF as much as €2 over the course of a year. “That’s a mere pittance,” you might say. For broad-market index ETFs, the TER is usually 0.07–0.25 % per annum, whilst for niche and sector-specific ETFs it can reach 0.5–0.8 %. By way of comparison: actively managed funds charge 1.5–2 % per annum or more. The TER is automatically deducted from the ETF’s value and, in practice, this fee is “invisible”. But the lower it is, the better, and the more effectively the ETF will track the index’s performance.
2. We play for high stakes. No small-scale funds. The fund’s assets under management (AuM) must be at least $400 Mio. It stands to reason that the more people have entrusted their hard-earned money to a fund, the more reliable that fund should be. Furthermore, large funds generally charge lower fees because they can afford to do so.
3. Date the fund was established. The longer a fund has been in existence, the less likely it is to be wound up. Where possible, we should choose the oldest funds.
4. We choose physical replication. The objective of an ETF is to track (replicate) the performance of a specific index (or asset). Based on the replication method, ETFs can be divided into two types:
1. Physical replication (the fund directly holds the shares from the index);
2. Synthetic replication (or “SWAP”) (the fund does not hold any securities included in the index).
Instead of them, there are swap contracts between the management company and banks. We choose funds with physical replication. They are more transparent.
5. Portfolio composition. It sometimes happens that a single company accounts for up to 20% of the fund. That’s too much. We make sure there isn’t a significant imbalance towards one (or two) companies within the ETF’s portfolio.
6. No leveraged and inverse ETFs.
“Everything ingenious is simple, and everything simple is ingenious” — this phrase simply reflects the main principle of ETF selection perfectly. Start with the simplest strategies. Still want to bring elements of personal creativity into your portfolio? Then set aside a specific amount for this purpose (a small one) (!) part of your portfolio and do whatever takes your fancy.

What articles about ETFs usually leave out

Replication method: physical, sampling, synthetic

Full physical replication — the fund really does buy all the securities of the index in the same proportions. The most transparent option, applicable where there are few securities.

Sampling — the fund buys a representative sample instead of all the securities. That is how most MSCI World funds are set up: holding fifteen hundred positions is expensive. Technically, this is also physical replication.

Synthetic replication via swap — the fund holds a basket of arbitrary securities and swaps its return for the return of the index under a contract with a bank. Tracking is more precise and cheaper, but counterparty risk is introduced. Under UCITS rules, this is limited and usually covered by collateral, but it does exist.

UCITS and fund jurisdiction

Virtually all ETFs available in Germany operate under the European directive UCITS: mandatory diversification, daily liquidity, regulatory oversight. This can be seen right in the fund’s name.

The domicile is usually Ireland (ISINs beginning with IE) or Luxembourg (LU). Irish funds benefit from a more favourable tax treaty with the US: a withholding tax of 15 % is applied to US dividends instead of 30 %. For a fund with a large US exposure, this makes a significant difference to the final return, although this is not explicitly stated anywhere in the prospectus.

Accumulating and distributing

Accumulating reinvests dividends within the fund, while distributing pays them out to an account. During the accumulation phase, the first option is usually chosen, and for annual use of the tax-free allowance, the second. The tax side of the matter has been analysed. on the ETF page.

Tracking Difference is more important than TER

TER is the stated fee, while the Tracking Difference is the fund’s actual lag behind the index over the year. Sometimes it is less than the TER: the fund earns extra money by lending out securities (Wertpapierleihe) and partially offsets its costs. Sometimes it is more due to dividend taxes and rebalancing costs. It is more accurate to compare funds by their Tracking Difference over several years rather than by a single TER figure.

Fund size and risk of closure

Funds with a volume of under €100m are regularly closed by providers: maintaining them is unprofitable. Closure does not mean losing money — the fund is liquidated and the value of the units is paid out. But this is a forced sale, which means capital gains tax at a time you did not choose. Another argument in favour of large, long-established funds.

What to read next

Where to open an account and how taxes are calculated — broker comparison, Abgeltungsteuer, Vorabpauschale with a calculation example.
ETF-Sparplan — how to set up regular purchases, contribution indexation, employer-sponsored VL (Vermögenswirksame Leistungen).
DAX — Germany’s main index and why it cannot be compared directly to the S&P 500.

The material is for informational purposes only and does not constitute an individual investment recommendation. The value of securities may rise and fall, and past performance is no guarantee of future results.