Buying an ETF: You should pay attention to these criteria when making your selection

ETF: What is it anyway?

Exchange Traded Fund, or ETF for short, means “exchange-traded fund”. Compared to actively managed investment funds or certificates, it is simple and very transparent. However, a stock ETF that aims to build wealth or provide for retirement should have as wide a spread as possible – ideally worldwide – via a suitable index. However, this is not the case for many stock ETFs, which is why they are not suitable for these goals. You should therefore find out about the most important selection criteria in advance.

Information on the criteria for ETFs can also be found in the relevant “key investor information” or in the “fact sheets” of the funds. You can access them on the websites of your bank, the investment company or in financial information portals on the Internet. You can read more about the advantages and disadvantages of ETFs in the linked article.

The index shown

An ETF passively tracks an index rather than actively pursuing its own investment strategies. This makes it all the more important that investors select the right index for their investment goal.

Some indices only contain a few stocks or are calculated according to criteria that are difficult to understand. This is often the case with so-called industry, strategy or factor indices. For example, they try to combine stocks with particularly high dividend payouts or particularly high-growth companies in an industry in an index.

Such ETFs are not the first choice when building assets because they usually only achieve below-average returns. Above-average returns here are purely a matter of luck. Broad risk diversification and low costs are crucial for a successful investment strategy. The following indices are examples of this:

The aim of the aforementioned indices is to replicate the development of stock markets worldwide. Investors can also achieve global risk diversification by combining indices from the major investment regions. Then the following indices come into question:

• Europe: Stoxx Europe 600, MSCI Europe, FTSE Developed Europe,
• North America: S&P 500, MSCI USA, MSCI North America,
• Emerging Markets: MSCI Emerging Markets.

There are ETFs from various providers for all of the indices mentioned. They all bear the name of the index, usually supplemented by the name of the publisher and an abbreviation that indicates the use of the proceeds. ACC stands for income accumulation, DIS for income distribution.

There are also a variety of indices for ETFs that invest in bonds instead of stocks. They are generally less well known than stock indices. Examples of indices in euros are:

• Corporate bonds in euros: Bloomberg Euro Corporate Bond Index,
• Government bonds of the Euro member countries: Bloomberg Euro Aggregate Treasury Index, iBoxx EUR Sovereigns Eurozone or Bloomberg Euro Government Bond 1-3yr Index.

But the same applies here: Investors should look at what is in an index. The information is available in the index provider's fact sheets, which you can find online by searching for the index name and a PDF file. For example, things are important

• the remaining terms of the bonds included,
• the creditworthiness of the issuers, with government bonds being safer than corporate bonds and
• the currency in which the bonds are quoted.

The costs

Ongoing costs reduce the return. Compared to actively managed funds, almost all ETFs are inexpensive. Actively managed equity funds charge an average management fee of around 1.5 percent per year. For ETFs it is usually less than 0.5 percent per year. In addition, the transaction costs for ETFs are much lower because the securities contained in the fund are not bought and sold as often as is the case with active investment strategies.

For ETFs with global diversification, investors do not have to pay more than 0.4 percent management fees per year. For ETFs with an investment focus on industrialized or emerging countries as well as Europe, the running costs are even lower; there is enough choice with an expense ratio of less than 0.2 percent per year.

The type of use of income

Stock ETFs regularly receive dividends from the companies whose shares they hold. Bond ETFs receive interest payments from the issuers of the bonds they hold. Like other mutual funds, ETFs differ in what they do with that income. Basically there are two options:

• to distribute, or English “distributing” or
• accumulating, or English “accumulating”.

Distributing ETFs pass on dividends and interest directly to investors once per quarter or per year. The money is then posted to the depot's clearing account. The share price of the ETF decreases by the amount of the distribution. You can then either reinvest the payout or use it elsewhere.

Accumulating ETFs On the other hand, the funds they receive are reinvested in purchasing the fund shares. So the money stays in the fund and investors don't have to worry about reinvesting it. However, they also have no ongoing income.

For tax purposes, distributing and accumulating ETFs are treated similarly. You can therefore choose a use of income that best suits your investment objective. When it comes to long-term wealth accumulation, accumulation is usually the most convenient option.

The fund volume

A simple rule of thumb applies to this criterion: Only choose funds that have at least around 500 million in fund volume. The smaller the assets managed in an ETF, the greater the risk that the fund company will eventually close the fund or that it will be merged with another fund. While neither is a disaster, it can incur additional costs if you want to reinvest your funds.

Larger providers have an advantage in this regard because their funds often manage more funds. And widely used indices are once again better than exotic ones.

The fund currency

Some ETFs are traded in US dollars (USD), others in euros. However, which currencies are included in the fund assets only depends on the respective securities. Shares of American companies are always traded in US dollars, shares from Switzerland are always traded in Swiss francs, etc.

With an ETF that is diversified worldwide, you automatically always hold a broadly diversified basket of currencies. Because most and the largest stock companies worldwide are based in the USA, the US dollar dominates as the currency in the portfolio of ETFs that track the MSCI World, the MSCI All Country World or the FTSE All-World. This sometimes increases or reduces investors' return in euros, depending on how the exchange rate develops.

The currency of the ETF is therefore not a selection criterion. You have to take this into account. If you don't want to bear currency risks, you either need to choose ETFs that hedge these risks. They are usually marked with the addition “EUR hedged”. But this is expensive, which is why consumer advice centers advise against it if you have a long-term investment strategy. Alternatively, you can also select ETFs that only contain securities from the euro area.

The structure of the fund

ETFs replicate indices in three main ways: complete, optimized or synthetic. All 3 procedures have their place and are no worse or more risky than the others.

1. Either they actually hold all the stocks in an index directly – in the same proportion as they are represented in the index. This procedure is called full replication (Replica). It is usually not offered because full replication is expensive, especially for very large indices that also contain many smaller stocks.
2. The funds usually only contain a selection of the stocks in the index, supplemented by a few derivatives. Then we speak of one “optimized” replica.
3. At the synthetic replication An ETF directly holds securities that have nothing to do with the index and at the same time enters into a contract, a so-called swap agreement, with a bank. It undertakes to compensate for the differences between the development of the index and the basket of securities held by the fund.

You can read detailed explanations of how an index is mapped in this article.

The tracking difference

The tracking difference quantifies the difference between the return of the fund and the return of the index. Theoretically, it corresponds approximately to the amount of the running costs. In practice it is sometimes higher, sometimes lower. There can be various reasons for this:

• How is the tax deduction for income distributions in the index and the actual taxes on the fund assets calculated? For some indices, e.g. Euro Stoxx 50, the return of the ETFs is regularly even higher than that of the index (but that does not mean that these ETFs are better than others).
• What does the liquidity position look like, for example after dividend distributions? More liquidity when stock prices rise increases the tracking difference.
• Have income from securities lending been credited? Some providers credit more than others, which reduces the tracking difference.
• What is the timing of index adjustments? The stocks that are included in the stock indices are exchanged from time to time. This can also result in a (random) difference to the index.

For the major global stock indices mentioned above, the tracking differences are very small. However, they are not shown separately anywhere, which makes comparison difficult. After all, you can see it indirectly in the fund's returns over the last calendar years if you compare this return with that of the index.

When making this comparison, make sure that the currency of the fund and the currency of the index match. Some providers show the returns in USD in the fact sheet if the index is calculated in US dollars. This is regularly the case with all global indices. Other providers show the returns in euros in the fact sheet, including those of the indices.

Stiftung Warentest offers a comparison of different ETFs online and in every monthly magazine.