ETFs: The investment revolution

As we have already shown in previous articles, there is no getting around the asset class “equities” when it comes to long-term, return-oriented investments. However, instead of taking an unnecessarily high risk with a handful of individual stocks, an ingenious alternative has established itself on the investment market in recent years: Exchange-traded index funds, better known by the acronym “ETF” (Exchange Traded Fund). In this article, you can find out why the global triumph of ETFs is not just hype, but based on hard facts.

So it happened this summer: The five trillionth US dollar was invested in an ETF. Since the beginning of the year, the global ETF volume has grown from 4.7 to 5.2 trillion US dollars, or 5,200,000,000,000 in figures. Invented 25 years ago and hidden away in a niche for a long time, the enormous rise in recent years shows what a great idea it was to launch this form of investment.

History of ETFs – How it all began

The predecessors of ETFs were created back in the 1970s. These were passive index funds, but they were not yet traded on the stock exchange. In 1971, the first index fund

Samsonite Pension Fund” was created for professional investors by Bill Fouse and William Sharpe. The first index fund for private investors followed in 1975. This was the “Vanguard 500 Index Fund” from the investment company of the same name, which was founded by US investment legend John “Jack” Bogle had founded shortly before (see Figure 1)

It was not until many years later, on January 22, 1993, that the first exchange-traded index fund was launched on the market. The “SPDR Standard & Poor’s 500” (stock ticker SPY) was launched on the market by the asset management company State Street Global Advisors. The “Spider”, as it is also known colloquially, is now the world’s largest ETF with assets under management of around 250 billion US dollars. It tracks the performance of the 500 largest listed US companies. This laid the foundation for the brilliant success story of ETFs.

Market overview of ETFs in Switzerland

The first ETFs tradable on the SIX Swiss Exchange were launched in 2000. Since then, the ETF offering has also grown rapidly in this country.

Currently, 1,284 ETFs are already traded on SIX, spread across the following six asset classes (see Figure 2):

The fund assets of the individual ETFs range from less than CHF 1 million to over CHF 30 billion.

The annual fees (TER) range between 0.05% and 1.12% of the market value of the invested capital, with a downward trend.

While the US asset managers Blackrock (with the ETF label “iShares”) and Vanguard are the undisputed global leaders among ETF providers, the Swiss market is dominated by UBS and Blackrock .

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The index as the basis for ETFs

The purpose of a stock market index is to document market performance in a representative manner. Indices are subject to strict rules that define the selection procedure for the individual index components, specify the calculation method and document the regular review. In most cases, they are calculated by independent index providers such as MSCI (Morgan Stanley Capital International) or FTSE (Financial Times Stock Exchange).

“The most important criterion when choosing an ETF is the underlying index.”

For private investors, the underlying index is probably the most important criterion when choosing an ETF. This is because the index contains many aspects that are relevant for future returns. It is not a question of analyzing the individual companies in the index. Rather, it is important to check whether the country, region and sector weighting matches your own investment strategy.

“Despite a lot of media attention, there is no rational reason to invest in an ETF that tracks the SMI.”

The SMI (Swiss Market Index) is the best-known stock market index in Switzerland and unfortunately a very unsuitable one from an investor’s point of view. This is because it is completely inadequately diversified in many respects:

• Number of companies: only 20
• Uneven distribution: around 50% fall to the heavyweights Nestlé, Novartis and Roche
• Geographical: only one country (CH)
• Sectoral: Pharmaceutical industry is heavily overrepresented with a share of over a third

Despite the great media attention, we do not believe there is a single rational reason to invest in an ETF that tracks the SMI.

If it absolutely has to be a Swiss index, then the SLI (Swiss Leader Index) is the best choice. This contains the 30 largest Swiss stock corporations. The four most important stocks are each capped at 9%. If necessary, the index weighting of all other stocks is limited to 4.5%. This means that the SLI is better diversified than the SMI.

ETFs do not want to beat the benchmark index

Traditional investment funds attempt to achieve a higher return than their benchmark index, which is hardly ever successful in the long term due to the high costs of active fund management. (This has now been proven by countless studies).

ETFs do not pursue this goal. They “work” based on rules and are usually passive, i.e. they merely replicate the underlying index as closely as possible. The better this is achieved or the smaller the tracking difference, the better the ETF provider is doing its job. But once again: the underlying index is more decisive than the choice of ETF product.

In this detailed ETF comparison we have used a rigorous selection process to award prizes to the best ETFs that follow established, broad market indices.

ETFs are legally special assets

In Switzerland, ETFs, like traditional investment funds, are subject to the Federal Act on Collective Investment Schemes (CISA). They are legally special assets and remain the property of the investor in the event of the insolvency of the ETF provider or custodian bank.

Lots of light and hardly any shade

We are convinced that the ETF market will continue to grow strongly in the long term. This is because the advantages of ETFs, which track a broadly diversified index, over active investment funds and individual securities are rationally justifiable and scientifically sound. Below is a selection of the advantages offered by ETFs:

• Low entry barriers: For private investors, global, broadly diversified investing is possible with one transaction and no minimum amount
• Liquid, continuous trading via the stock exchange
• Cost-effective
• High transparency
• Dividend participation
• Special assets: protection in the event of insolvency of the provider or custodian bank
• Broad, constantly growing range

In principle, we do not see any relevant disadvantages of ETFs (but risks, see below). Nevertheless, here are three aspects that some investors might consider negative:

• No co-determination: An investor in an equity ETF is entitled to a dividend, but not to co-determination at the Annual General Meeting. Voting rights are exercised by the relevant fund company (e.g. Blackrock and Vanguard).
• Lack of identification: Individual shares in Apple, Facebook or Tesla may trigger emotions in some people. People identify with these companies (or not). With ETFs, this company-specific identification factor is naturally absent.
• Lack of thrills: ETFs are downright boring in times of Bitcoin & Co. Anyone looking for a quick buck (and willing to accept a total loss) will not be happy with ETFs.

“ETFs are often a thorn in the side of the traditional financial industry.”

And another thing: quite a few providers of traditional funds, i.e. with active asset management, are a thorn in the side of ETFs. This is because active asset management and customer advice are many times more lucrative for them (and unfortunately all too often only for them).

It is therefore not surprising that ETFs are often portrayed negatively in the media by lobbyists from the traditional financial industry. The necessary caution is therefore required here and the arguments put forward against ETFs should be critically scrutinized.

Risks of ETFs

Market risk is certainly the greatest risk with ETFs. If a market collapses, an investor who is invested in this market with an ETF is affected 1:1. After all, unlike an investment in an individual share, he is spared a total loss. In addition, past experience shows that although price losses can be severe even in a global portfolio, they are often only of a relatively short-term nature (see also this blog article).

With global investments or a global portfolio, there is of course also a currency risk. A distinction must be made between the following three currencies, which can differ for an ETF:

• Fund currency: Currency for calculating the ETF fund assets
• Trading currency: Currency in which the ETF is traded on a specific exchange
• Currency of the securities shown: Currency that significantly determines the currency risk

Our tip: Accept currency risks and do not hedge (expensively). This is because currency losses and currency gains largely balance each other out in the long term, especially in globally diversified portfolios.

We classify counterparty risk as more of a theoretical nature. This only affects synthetic ETFs (which are in sharp decline anyway) and ETFs that engage in securities lending. However, the latter is hedged by the fund providers. The value of the collateral must exceed the value of the asset lent.

So if you want to avoid counterparty risk, choose physically replicating (i.e. non-synthetic) ETFs that do not engage in securities lending.

Securities lending is attractive for investors in that they benefit from the additional income generated, which in turn improves the performance of their ETF and reduces the tracking difference.

“ETFs are the ideal instrument for self-determined, broadly diversified and cost-effective investing.”

Conclusion

ETFs are a success story and have revolutionized the investment market. In our opinion, they are the ideal instrument for self-determined, broadly diversified and cost-effective investing.

Figure 3 summarizes the most important aspects of ETFs:

The strong growth of the ETF segment has led to a large number of different product designs. It is therefore increasingly important, but also more challenging, for investors to obtain reliable information before making a purchase. In the next article, we will show which factors are particularly important to consider.

You can get a complete overview of the topic of “Investing” here: Learning to invest – in eight lessons.

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Disclaimer

Disclaimer: Investing involves risks of loss. You must decide for yourself whether you want to bear these risks or not.

Errors excepted: We have written this article to the best of our knowledge and belief. Our aim is to provide you as a private investor with the most objective and meaningful financial information possible. However, should we have made any errors, forgotten important aspects and/or no longer have up-to-date information, we would be grateful if you could let us know.