5 Points to consider when deciding for an ETF

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So you have taken the plunge and want to start investing into an ETF (exchange traded fund) - congratulations! Now you might be browsing ETF comparison sites (one that we use is justETF) and are already looking into the details of some ETFs on your short list. Sometimes, those details might be (partly) listed in any EFT overviews (and you might have wondered what they mean) - but another way to find out about this is to have a look  to do  the so-called "fact sheet" of a given ETF (or any investment product, they are have a fact sheet).

Financial terms alert.... we use some terms here that you may not be familiar with. Please look them up on places like Investopedia if you don't understand them. As we are just starting out with the blog we cannot cover them here now but we will strive to do so in the future. 

 

Below, we list 5 properties of ETFs to look for when deciding for an ETF

 

1. ETF investment focus 

this is the most important investment choice to make - as this essentially says what you are investing in. ETFs tend to focus on - and hence invest into a single area. Investment focus has many dimensions, but 2 of the most important ones are 

Asset type - what type of assets does the EFT invest in? Most people know Stock ETFs, where the ETF traces one of the well-known stock indices (like the S&P 500 or the MSCI world). This means the underlying investment is in stocks. But equally, there are Fixed-income ETFs (also called "Bond" ETFs) -investing in government or private bonds, Real-Estate or Commodity ETFs. As the ETF market is rapidly developing, almost every asset class will be covered by an ETF. Most people start with a widely diversified stock ETF, such as one tracing the MSCI world index.

Market segment focus - how broad does the ETF invest? Market segment focus includes the aspect of geography (from world-wide to very country / region specific), or a focus on a specific sector / industry (such as tech-focused or the pharmaceutical industry) or investment theme (e.g. sustainable investment, high dividend yield investment etc.). Market segment focus will directly correlate with risk and return as the more narrow the investment area gets, the more volatile the investment can be (but with potential upsides when chosing a well-developing segment). For starters with little previous knowledge, a broad, diversified focus (e.g. a world-wide focus) seems appropriate as it lowers risk over the long term.

 

2. ETF Income Distribution Policy

There are two different types of ETF when it comes to the distribution of income (in case of stock ETFs, the dividends that are paid out). Those are 

Accumulating ETFs - any dividends or other income received are automatically re-invested. This means they are not being paid out directly to you but it will be added to your invested money, therefore you can profit from compound interest over the long term. 

Distributing ETFs - any dividends or other income received are being paid out to you directly (usually to the account linked to your portfolio. 

Two things are important when considering either of those. Investment goals and taxation. For investment goals, if you have a long-term focus we recommend an accumulating ETF, as it will automatically re-invest income, increasing the size of your overall investment and carrying compound interest over the years. If you want to make a passive income from your investments straight away, then a distributing ETF will provide you with regular payouts. For taxation it depends where you live and we suggest checking on your tax situation. In the past, those two have been treated differently for tax purposes (payouts from distributing ETFs would get taxed as investment income as it was paid out whereas accumulating investment gains were not, as they were not realised). However, recently taxation has been harmonised in the EU, treating both roughly the same. Lastly, most trading platforms have added the option to automatcially re-invest any payouts from a distributing ETF, so you could use Distributing ETFs similar to Accumulating ETFs when pursuing a long-term startey (check for your tax situation!).

 

3. ETF Replication

The point of ETFs is to track a chosen index as closely as possible. In theory this would mean buying the exact same shares (or other assets) in the exact same composition as the index does and then buy / sell all the time as the index moves. While this is the underlying principle, there are two main ways to do this in practice. 

Physical replication: byuing physical shares / bonds etc. - replicating the index as it is (1:1) or by using sampling, where a selection / sampling of the elements is bought (usually using computer optimization) .

Synthetic replication: instead of buying the physical assets (like shares etc.) directly, the ETF usually invests in so-called "Swaps". Swaps are contracts with financial institutions (such as banks) which would promise to yield the same returns.

In practice, for you as a beginning investor, the replication method does not make a big difference. Sometimes, sythetic ETFs tend to have a lower annual cost (as less actual trading is done), but in recent times costs seem to have assimilated between the two. In terms of risk, some investors prefer physical replications, as the fund actually holds physical stocks rather than contractual promises. Given improved risk management and the extreme circumstances that would be required to make the difference between those count, we consider this choice a minor point.

 

4. ETF domicile and currency

ETF domicile means where the ETF fund is located. This is important for tax and regulatory issues. Often, similar ETFs are offered to investors in different countries, in sync with local regulations (e.g. big companies like Vanguard, iShares etc. sell different funds in the US and the EU). As always, check your tax implications before deciding for one (in case you have the choice). With regards to currency, sometimes the fund currency will change according to the domicile (e.g. some EU funds might be in EURO while others might be in USD). In general, please always check the currency of your fund and be aware of possible currency risks. There are funds that hedge the currency risk, sometimes at a small premium. 

 

5. ETF provider

Many of the "mainstream" ETFs are offered by many different companies. Which ones you can choose depends on your bank / investment depot and your location (not all companies offer all of their ETFs worldwide). When offered with two "similar" ETFs, it might be worth checking the providers for their reputation / credibility (how long have they been in the market?, how many assets do they have under management?, do they communicate their products clearly?) and to see whether there might be special offers with one or another provider and your depot / bank (e.g. to waive order fees). Important though- "brand" does not matter much in the ETF world - so important to look at the fees and not buy a more expensive ETF just because its from a certain provider- unless you have another good reason to do so.

 

We hope this overview has been helpful to you or clarified some questions you might have had when deciding to buy an ETF. If you want to read more on how to start your journey into financial independence, why don't you download our free e-book "Becoming Financially Independent" and subscribe to our newsletter?

 

A final note... Please remember that we are not licensed professionals or financial advisors. We are two friends who want to make the world a better place, in the best way that we can (read more about this in Our Pledge to You). We think that our knowledge and experience to build a better financial future is worth sharing with other women across the globe. But in the end, as we emphasize throughout this website, we are expressing our own opinions and this website is for sharing knowledge only. All content is to be taken as our personal opinions and not as financial advice. We are neither responsible nor liable for any money loss or suffering that our readers might face after reading this blog. 

 

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