ETFs Explained: What Retail Investors Need to Know

An exchange-traded fund (ETF) is a type of investment fund that can be traded on an exchange in much the same way as a stock. It combines many individual securities in a single “basket,” such as shares in different companies or bonds issued by different governments. When you invest in an ETF, you buy units in this basket and benefit from broad risk diversification.

The best-known ETFs track a prominent index such as the SMI, S&P 500, or DAX. If the index rises, the value of the ETF also rises. If the index falls, the ETF’s value declines accordingly.

For example, the Swiss Market Index (SMI) comprises the 20 largest Swiss companies, including Nestlé, Novartis, and Roche. An ETF tracking the SMI buys the index constituents according to their weightings. This means you do not need to buy each stock individually. A single ETF unit allows you to participate in the performance of all securities included in the index.

For a long time, the traditional distinction between ETFs and conventional investment funds was their management style. ETFs generally tracked an index passively, while traditional funds were actively managed. Today, however, both passive and active ETFs are available. A key difference therefore lies in their structure. ETFs are generally traded continuously on an exchange, whereas traditional funds can usually be bought or sold only once a day at their net asset value (NAV).

A particularly practical feature is that a single ETF can provide a broadly diversified portfolio. Many people therefore use ETFs to build wealth over the long term, for example through a savings plan with regular contributions. Performance consists of price gains and dividends. Depending on the type of ETF, dividends are either paid directly to investors or automatically reinvested. Reinvestment supports the effect of compound returns.

ETFs are generally available in two forms: actively managed and passively managed funds.

Imagine that you do not want to track the entire market through an index such as the SMI. Instead, you want to invest specifically in companies with certain characteristics. A smart beta ETF does exactly that. It selects stocks according to clear rules, such as companies with stable earnings, attractive valuations, strong price momentum, or low volatility. A traditional index weights companies by size. Smart beta ETF, by contrast, invests according to selected factors. This preserves the cost and transparency advantages of an ETF while offering the potential to generate higher long-term returns or reduce risk.

Distributing ETFs regularly pay generated income, such as dividends or interest, directly into your account. Payments may be made annually, semiannually, or quarterly. Accumulating ETFs, by contrast, retain this income within the fund and automatically reinvest it. This allows you to benefit from compound returns, but you do not receive regular payments. The more suitable option depends on your priorities and whether you prefer ongoing income or long-term wealth accumulation.

You can often identify whether an ETF is distributing or accumulating from its name. The suffixes “Dist” (Distributing) or “A-dis” indicate a distributing ETF, while “Acc” (Accumulating) indicates an accumulating ETF.

Physical ETFs buy the securities underlying the index directly. With full physical replication, the ETF invests in all index constituents according to their weightings. With optimized physical replication, it invests in a selection of constituents, which keeps costs low for very large indices. Synthetic ETFs instead replicate the index through derivatives, usually swaps with a bank. This is often more cost-effective, but it creates counterparty risk, which is legally limited to no more than 10% of the fund’s assets.

ETFs can invest in different asset classes, each with distinct opportunities and risks:

• Equity ETFs: Invest in company shares and offer growth potential, but are subject to greater price fluctuations

• Bond ETFs: Invest in government or corporate bonds and are generally more stable, with regular interest payments

• Money market ETFs: Invest in short-term, low-risk instruments that offer low but very stable returns 

• Commodity ETFs: Invest in gold, oil, or agricultural commodities and provide additional diversification

In addition to the TER, investors may incur other, less visible costs when buying and selling an ETF. One of these is the spread.

The spread is the difference between the bid price and ask price of an ETF on the exchange. A narrow spread means lower trading costs, while a wide spread means higher costs. For example, if the bid price is CHF 100.00 and the ask price is CHF 100.20, the spread is CHF 0.20, or 0.2%. The spread is typically narrowest when the underlying securities are also being traded. For a US equity ETF, this is the case from 3:30 pm Swiss time. Choose ETFs with high trading volumes and trade during periods of high market activity. Limit orders can also help keep spread costs low.