ETFs Explained Easily
Your guide to relaxed investing in the stock market
If you already know how an ETF works, skip the introduction — the rest of the article will cover the many advantages.
ETF stands for Exchange-Traded Fund, an investment product that is tradable on the exchange. An ETF always represents a collection of shares, a so-called index.
Indices can be country-specific, such as the S&P 500, or the NASDAQ, but can also cover the whole world or certain types of companies and industries.
So an ETF invests in an index; it buys the stocks listed in it. The money for investing comes from the investors who buy the ETF on the exchange.
The provider takes the money and buys the shares. Unlike shares, however, ETFs are not bought or sold traditionally on the stock exchange — their price is not determined by supply and demand, but is based on the value of the shares.
This is logical because the provider who buys the shares for the investors has to pay more if the shares in the index tend to become more expensive.
Here is an illustration:
- An index is not a basket of shares from which is bought directly. The index provider does not own the shares. It is a listing, like a recipe. A Vanguard ETF on the MSCI World does not buy the shares from MSCI, but those listed by MSCI in its index, the MSCI World.
- The legal owner of the shares is the provider of the ETF. The shares are deposited with him — but they were bought with the money of (mostly) private investors.
- An index comprises not only the shares themselves but also a weighting for them. Apple has a share of about 2% in the MSCI World, Microsoft only about 1%.
Now you know roughly how an ETF works. Let’s take a look at what good reasons there are for ETFs.
As you now know, an ETF is a collection of stocks. So when you buy an ETF, you are automatically invested in several shares at once — thus reducing your risk and costs.
Why do you reduce costs? Because investing in an ETF, i.e., investing in several shares simultaneously, is only one transaction. Just like when you buy x pieces of one share. But if you buy, e.g., 10 times Google and 5 times Apple shares, these are two different orders that usually cost money with your broker.
Important: Just because you invest in several shares does not automatically mean you are super safe. Some ETFs only invest in individual sectors, e.g., the banking sector — this is, of course, less safe than investing in all sectors worldwide with one ETF.
Overall, however, ETFs tend to be safer and cheaper.
Precise Investment in Return Factors
Scientifically proven, there are so-called return factors. This refers to the factors that are responsible for the actual return.
ETFs are particularly good at investing in these factors, as they usually cover types of companies. This type of investment is also called factor investing.
The return comes from risk. More risky stocks are, for example, those from emerging markets, but also the stocks of smaller companies.
Therefore, one speaks of the political-risk and the small-cap factor.
Hardly anyone knows of even 10 stocks that belong to both categories — but with ETFs, you can invest in 100 to 1000 of these companies at the same time.
These factors usually generate a little more return than the market average — but of course, they are not available for free.
Stocks from emerging markets, or politically risky countries, usually have much greater fluctuations.
Factor investing is also not suitable for getting rich quickly. While the global stock market generates an average annual return of around 6–7%, we are talking about an average annual return of around 8–10% for the emerging markets.
With ETFs, you can invest in these factors at a low cost without much effort without knowing any of them.
Some stock companies distribute a profit-sharing bonus. So-called dividends — you then receive these per share you own in the company.
There are two types of ETFs, which differ in how dividends are handled.
- Distributing ETFs pass on the dividend to investors.
- Accumulating ETFs use the dividend and reinvest it directly. Of course, the investor also benefits because new shares are bought, and they have a fixed share in the pool.
So both are legitimate models of how ETFs deal with dividends. With both models, the investor benefits from the dividends paid out by the companies — directly or indirectly.
The second model's advantage is that the distribution is directly reinvested without the investor having to worry about it himself.
In the first model, he might receive, for example, a dividend of $10, which he now has freely available. However, he would like to reinvest the money in an ETF, which currently costs $25.
So he has to wait for 3 more dividends and then buy 2 new ETF shares — if he does not do it through a savings plan, this usually costs him a transaction fee.
I think the disadvantage becomes clear — the effort and the costs are higher. In the worst case, the ETF to buy rises in price after the distributions, so he has missed out on returns.
Savings plans for ETFs are no longer unusual for most providers. For individual shares, the situation is still different for many. Even if there are savings plans for individual shares, the effort to organize them is much greater.
An ETF savings plan, on the other hand, allows you to invest automatically and regularly according to your own wishes — and often even free of charge or at better conditions.
With my broker, it is anyway very cheap to buy shares and ETFs. However, savings plans for ETFs are completely free of transaction costs, particularly attractive for people who invest smaller sums.
Reinvesting dividends is, therefore, automatically possible with ETFs.
Yes, even with individual shares, there is sometimes the option of reinvesting dividends directly instead of paying them out — but in most cases, it is up to the stock company itself, and in a large portfolio with many shares, the effort involved is very great.
Avoiding Investing Biases
The shares we know is a drop of water, but all shares in which one could invest is a whole ocean.
The home bias shows very well that investors subconsciously tend to invest in companies that come from their country, which they may even know well.
But that is a big mistake, as it only increases the risk unnecessarily.
A government crisis, for example, could lead to extreme drops in shares from the country. The shares of other countries are not affected. Bad luck for the person who then only invested in the country’s shares.
Almost always, when we select individual stocks in which we want to invest, we are inferior to the biases. I have written an article on other popular biases:
After all, an ETF is just a collection of shares. Nevertheless, many ETF portfolios often generate a higher return than the portfolios of people who invest in individual shares in a well-considered way.
There are the following reasons for this:
- Higher costs. Mainly because investors who buy individual shares sell and buy them more often — for example, if they think they can foresee a drop.
- Market-timing. People who invest in single shares often wait with larger sums they want to invest — to find the right time for investing.
On average, however, this does not work out — the stock market ultimately performs positively, so on average, the highs are stronger than the lows.
- As already mentioned, higher returns can be achieved with factor investing. However, implementing factor investing without ETFs is very complex and costly. However, since buyers of individual shares are subject to home bias anyway, they usually invest little or not enough in factors.
- The home bias also ensures a generally poorer diversification. Insufficient diversification, therefore usually results in an unnecessarily higher risk.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
20 year old writer from Germany - Tech, Finance, Philosophy & Psychology