What are ETFs?

If you’ve already spent a bit of time on our blog, you’ll have noticed that we’re big fans of ETFs. And yes, this passive, broadly diversified and super cheap investment instrument really has won us over. Because we’re convinced that ETFs offer almost perfect investment opportunities, especially for every rational private investor and every self-directed investor.

That’s why we’ve created an easy-to-understand ETF infographic for you that gives you a brief, concise overview of the most important features of ETFs, their pros and cons and a few historical facts.

What are ETFs? In a nutshell

An exchange-traded fund (ETF) is an investment fund that is traded on a stock exchange, just like a share. ETFs are similar to mutual funds, with the difference that ETF units can be bought and sold throughout the entire trading day. Mutual funds are only traded at the close of trading.

ETFs combine the best features of two popular investments: they offer the diversification benefits of mutual funds while mimicking the ease with which shares are traded. Like any financial product, ETFs are not a one-size-fits-all solution. Judge them on their own merits, including management costs and commissions (if any), how easily you can buy or sell them, and their investment quality.

ETF = exchange-traded fund = a fund traded on the stock exchange

An exchange-traded fund – better known by the acronym “ETF” – is a fund that can be traded on a stock exchange like a share (hence the name). ETFs give you the opportunity to buy and sell a basket of assets without having to buy all the components individually.

An ETF works like this: the fund provider owns the underlying assets, designs a fund that tracks their performance and then sells units in this fund to investors. Unitholders own part of an ETF, but they don’t own the underlying assets in the fund. Nevertheless, investors in an ETF that tracks an equity index receive lump-sum dividend payments or reinvestments for the shares that make up the index.

While ETFs are designed to track the value of an underlying asset or index – be it a commodity such as gold or a basket of shares such as the Swiss Market Index – they trade at market-determined prices that usually differ from that asset. In addition, an ETF’s longer-term returns differ from those of the underlying asset due to factors such as costs.

How ETFs work – explained in 3 steps

1. An ETF provider looks at the universe of assets, including shares, bonds, commodities or currencies, and uses it to create a basket with a unique ticker.
2. Investors can buy a unit of this basket, just like buying shares in a company.
3. Buyers and sellers trade the ETF on a stock exchange throughout the day, much like a share.

Differences between ETFs, mutual funds and shares

In general, ETFs have lower fees than mutual funds – and that’s a big part of their appeal. While the average Swiss equity fund charges 1.42% in annual management costs – the so-called expense ratio – the fees for the average equity ETF are 0.53%.

Within a mutual fund (especially actively managed funds), there is usually more turnover than in an ETF, and such purchases and sales can generate capital gains. Similarly, when investors want to sell a mutual fund, the manager has to raise cash by selling securities, which can also trigger capital gains. In both cases, the investors have to pay these taxes.

ETFs are becoming increasingly popular, but there are still more mutual funds available. The two products also have different management structures (typically active for mutual funds, passive for ETFs, although actively managed ETFs also exist).

Like shares, ETFs can be traded on the stock exchange and have unique ticker symbols that let you follow their price activity. There’s SPY for one of the ETFs that track the S&P 500, and fun symbols such as CYBER for a cybersecurity fund and FONE for an ETF focused on smartphones. That’s where the similarities end, however, because ETFs represent a basket of assets, while a share represents just one company.

4 types of ETFs: equity ETFs dominate the market

ETFs may trade like shares, but under the hood they are more like mutual funds and index funds, which can differ greatly in terms of their underlying assets and investment objectives. Below you’ll find some common types of ETFs – but bear in mind that these categories aren’t mutually exclusive. For example, an equity ETF can also be index-based and vice versa. These ETFs are categorized not by type of management (passive or active), but by the type of investments held in the ETF.

Equity ETFs

These hold shares and are generally intended for long-term growth. Although they are usually less risky than individual shares, they are somewhat riskier than some of the others listed here, such as bond ETFs.

Commodity ETFs

Commodities are raw materials that can be bought or sold, such as gold, coffee and crude oil. Commodity ETFs let you bundle these securities into a single investment. With commodity ETFs, it’s particularly important to know what’s inside – do you have a stake in physical holdings of the commodity in the fund, or do you own shares in companies that produce, transport and store these goods? Does the ETF contain futures contracts? Is the commodity considered a “collectible” in the eyes of the IRS? These factors can have serious tax consequences and involve different levels of risk.

Bond ETFs

Unlike individual bonds, bond ETFs have no maturity date, so they are most commonly used to generate regular cash payments to the investor. These payments come from the interest generated by the individual bonds in the fund. Bond ETFs can be an excellent, lower-risk complement to equity ETFs.

Sector ETFs

The Swiss stock market is divided into 11 sectors, each made up of companies operating in that sector. Sector ETFs offer a way to invest in specific companies within these sectors, such as healthcare, financials or industrials. They can be particularly useful for investors who follow economic cycles, as some sectors tend to perform better during expansions and others during contractions. These ETFs often carry a higher risk than broad-market ETFs.

Advantages of ETFs

Diversification

While it’s easy to think of diversification in terms of broad market verticals – shares, bonds or a particular commodity, for example – ETFs also let investors diversify across horizontals, such as industries. Buying all the components of a particular basket would take a lot of money and effort, but at the click of a button, an ETF brings these benefits to your portfolio.

Transparency

Anyone with internet access can look up the price activity of a particular ETF on a stock exchange. In addition, a fund’s holdings are disclosed to the public daily, whereas mutual funds do this monthly or quarterly.

Low fees

Anyone with internet access can look up the price activity of a particular ETF on a stock exchange. In addition, a fund’s holdings are disclosed to the public daily, whereas mutual funds do this monthly or quarterly.