December 14, 2018

ETF Index Error 6: Index-Funds are simple

No two ETFs are the same. They each have a few "pros" and a few "cons" compared to their alternatives. To understand the implications, one needs to know five ETF characteristics: profile, cost, liquidity, risk and regulatory aspects.

If you don’t want to keep reading at this point, then we understand completely – in this case, you’ve probably already realized that ETFs aren’t simple, as is often claimed. However, if you want to learn a bit more about ETFs, then we will try to explain them to you as simply as possible.

The profile of an ETF is in itself often confusing: What does it even invest in? The names won’t tell you anything – the Swiss Market Index (SMI) for instance contains twice as many banks and five times as many pharma assets as the real economy. The global index (MSCI World) contains 60% US stocks and 20% of it is based in the finance sector. The SMI is therefore not Switzerland and the MSCI World is not the world. The DAX isn’t Germany, the FTSE isn’t England and the Nikkei isn’t Japan. No index is exactly what its name might suggest.

The second point, the costs, also create more confusion than clarity. For instance, the total expense ratio (TER) isn’t the same as the total costs. These also contain trade costs, which can be many times higher than the TER. Then there are the so-called "tracking error" which may contain additional costs and which requires a doctorate in financial theory and mathematics to understand it.

Things get really complicated (bear with us, you’ve almost made it) when it comes to solvency. You would think that ETFs are always solvent because you can buy and sell them on the stock market every day. However, this is only the case if times are good – if things go south, then they do so even more for the ETFs. Many ETFs contain so many stocks that they can’t even be sold quickly enough to keep up with the rate at which investors sell their ETFs. This additional loss in value can amount to a whopping 10%. During crises, you, therefore, lose more with ETFs than you would if you had invested in their stocks directly.

The risk of ETFs is another point many investors get wrong because they assume that ETFs are broadly diversified and therefore secure. However, for many ETFs, this isn’t the case – their capital is invested in a few stocks in a few different industries. Half of the assets in the SMI, for instance, are invested in just three or four stocks.

Some ETFs go even further and don’t even contain stocks, but rather make bets on stock prices with other financial institutions. If this goes wrong, the entire capital is gone.

We don’t even want to go into the regulatory framework conditions of ETFs (which you’ll probably be happy to hear). We’re sure you’ve realized by now that ETFs are many things, but what they are definitely not is simple.

Sources: on ETF evaluation, more about ETF evaluation, Investor ETF book.

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