ETFs

Exchange Traded Funds

An ETF (exchange-traded fund) is a special type of investment fund that can be traded on the stock exchange – much like a stock. Imagine you want to invest not only in a single company, but in many different companies and industries. This is exactly what an ETF makes possible. It bundles many individual securities – for example, shares of different companies or bonds of different countries – in a single "basket". When you invest in this ETF, you acquire shares in this bundle and benefit from a broad spread of risk, also known as diversification.

The best-known ETFs track a well-known index, such as the DAX or the SMI. If the index rises, the value of the ETF also rises, while if the index falls, it decreases accordingly. This can best be explained with an example: In an index, such as the Swiss stock index (Swiss Market Index; SMI), large companies such as Nestlé, Novartis or Roche are included – but with different weightings, depending on the size of the company. An ETF replicates this index by buying the stocks it contains in exactly those shares. As a result, the ETF reflects the composition of the index. The advantage: Instead of having to buy Nestlé, Novartis or UBS individually, the purchase of a single ETF share is enough to participate in the development of all the stocks included in the SMI . The principle: Selection and weighting in the index → replication by the ETF (replication).

From an investor's point of view, it is particularly practical that when you buy an ETF unit, the risk is spread over many different individual stocks. If a company or industry does worse, the loss is partially offset by other, positive developments. At the same time, you can easily buy or sell an ETF on the stock market whenever you want – unlike traditional mutual funds, which are often only traded once a day. Another major advantage of ETFs is their comparatively low costs. Because many ETFs only "replicate" an index and do not need a fund manager (keyword passive investment strategy), the management fees are usually lower.

Like all investment funds, ETFs are a collective investment scheme. They therefore represent a diversified investment vehicle with professional management. In addition, they are subject to special legislation and regulatory supervision in their countries of domicile. A key feature is that these are special funds: the investors' funds are managed strictly separately from the fund company's own funds and are therefore particularly protected.

It is particularly practical that a broad portfolio can be built up with just one ETF. Many people therefore use ETFs for long-term asset accumulation, for example via a savings plan with regular payments. The performance is made up of both price increases and dividends. Depending on the type of ETF, the dividends are distributed directly to investors or automatically reinvested, which supports the compound interest effect.

Another advantage is transparency, the composition of an ETF can usually be viewed daily via the ETF provider's website. This means that investors always know exactly which companies or stocks they are invested in. Providers publish factsheets, graphs, and updates that give investors a clear overview. Overall, ETFs are considered flexible, cheap and easy to understand. That's why they have become one of the most popular forms of investment for private investors in recent years.

Differences Between Actively and Passively Managed ETFs

ETFs are basically available in two variants: actively managed and passively managed funds.

Passive ETFs try to track the performance of a particular index as closely as possible. One example is the SMI, which includes the 20 largest Swiss companies, or the MSCI World, which includes stocks from many countries worldwide. A passive ETF therefore automatically buys all, or at least very many, of the stocks contained in this index and in exactly the same weighting as in the index itself. Since there is no elaborate selection by humans, the costs are low and the performance is very close to that of the underlying index.

Active ETFs are managed by one or more fund managers. They actively decide which stocks or bonds to buy or sell, or overweight or underweight, rather than simply following an index. The goal is to achieve a better return than the market through a clever selection of securities. For example, managers can focus on interesting trends or try to avoid risks in a targeted manner. However, actively managed ETFs are usually more expensive and it is debatable whether it is possible to really beat the market in the long term.

Smart Beta

Smart beta is an investment strategy that lies between classic passive investing and active fund management. While passive funds simply replicate an index (such as the SMI) and active management allows a fund manager to decide on the composition of the ETF on a discretionary basis (at their own discretion), smart beta combines both approaches. Rule-based and transparent investments are made in so-called factors, such as company size, quality, momentum or fluctuation intensity. The aim is to systematically improve the market return and achieve an additional return – also known as an "active return". For private investors, this means that smart beta offers the cost and transparency advantages of index funds, but at the same time has the chance of better performance through the targeted use of scientifically proven investment strategies.

Imagine that you not only want to track the entire market – for example via an index such as the SMI – but also invest specifically in companies that have certain characteristics. A smart beta ETF does just that. It selects stocks according to clear rules, such as companies with high quality (stable earnings), with favourable valuations, which have recently had strong price momentum or whose prices fluctuate less strongly (low volatility). Instead of simply buying all companies according to their size, as is the case with the classic index, a smart beta ETF invests specifically in these factors. This retains the advantages of a cheap, transparent ETF, but at the same time offers the chance to achieve a slightly better return in the long term or to reduce the risk.

Distributing and Accumulating ETFs

You can decide for yourself how you deal with the income of an ETF – a distinction is made here between distributing and accumulating ETFs.

Distributing ETFs regularly distribute the income generated during the year – such as dividends from shares or interest on bonds – to investors. This can be done once a year, semi-annually or quarterly. These funds will be transferred directly to your account and you can use them freely or reinvest them.

Accumulating ETFs, on the other hand, remain somewhat more passive: the income is kept in the fund and automatically reinvested. This means that you benefit from the compound interest effect – your shares increase in value because the income generated is reinvested directly. You don't need to make a new decision and the value of your investment can grow faster. However, you will not receive regular payouts.

Synthetic vs. Physical ETFs

ETFs allow investors to invest in many securities easily and cost-effectively – there are two basic types:

Physical ETFs buy the underlying securities of the index directly (e.g. stocks or bonds).
With fully physical replication, the ETF invests in all the stocks included in the index according to their weighting.
With optimized physical replication, the ETF invests only in a selection of stocks from the index, with the goal of achieving a very similar performance to the index, while keeping the costs for the fund low. Optimised physical replication is particularly used for very large indices in order to reduce the purchase of several hundred or thousands of securities and reduce the costs for the fund.
They are transparent, as you can see exactly which assets are in the fund, and the risk is rather low.
Synthetic ETFs do not track their index through real securities, but usually via derivatives (usually swaps) with a bank, without owning the securities directly. They are often more cost-effective and can better reflect hard-to-reach markets, but carry a certain counterparty risk (solvency of the counterparty). By law, the counterparty risk from a swap is limited to a maximum of 10% of the fund's assets. In practice, it has been shown that this risk is much lower through various measures, such as multiple counterparties.

Trading Currency

The trading currency of an ETF indicates the currency in which it is traded on the stock exchange. Possible currencies are, for example, Swiss francs, euros or US dollars.

It is important to note that the trading currency does not automatically have to be the same as the currency of the ETF's assets (fund currency) or the currency of the underlying index. For example, an ETF that holds investments in US dollars can still be traded in Swiss francs.

For private investors, the trading currency is particularly relevant if they buy the ETF on an exchange where it is not listed in their home currency. In this case, exchange rate fluctuations create an additional currency risk. In addition, trading on foreign exchanges may incur additional costs for settlement and currency exchange.

For many retail investors, it is therefore practical to trade ETFs in their own home currency to avoid unnecessary exchange rate costs and complexity. However, the trading currency itself has no influence on the return of the ETF, as the value of the investment is always converted into the investor's home currency.

Currency and Hedged ETFs – How Does It Work?

Many ETFs contain securities from abroad, for example American stocks or bonds from other countries. This creates a currency risk: exchange rate fluctuations between your home currency (e.g. Swiss franc) and foreign currency (e.g. US dollar) can affect the performance of your investment.

Non-hedged ETFs leave this risk in place. If the foreign exchange rate falls (for example, if the dollar weakens against the euro), this will have a negative impact on your return – even if the underlying securities have risen.
Hedged ETFs, on the other hand, try to minimize this risk. They take out a kind of insurance against exchange rate fluctuations, the so-called "currency hedge" or "hedging". This keeps the value of your investment more stable and more closely tied to the performance of the underlying securities.

It is important to know that hedged ETFs usually have slightly higher costs and the hedging does not always work perfectly.

Different Asset Classes

ETFs can invest in different asset classes, which means different types of assets:

Equity ETFs: Investing in company shares. Equities offer growth opportunities, but they are also associated with higher price fluctuations. When companies do well, you benefit from rising prices and dividends. At the same time, however, the value can also fall if companies or the entire economy develop worse.

Bond ETFs: Investing in fixed-income securities, such as government bonds (e.g. from Switzerland or the USA) or corporate bonds. They are usually less susceptible to fluctuations than shares and offer regular interest payments. The yield is usually somewhat lower.

Money market ETFs: Investing in very short-term, safe investments such as overnight or term deposits. The return here is often low, but these ETFs are very stable and are good for safely parking money in the short term.

Commodity ETFs: Investing in commodities such as gold, oil, silver or agricultural products. This asset class often behaves independently of equities and bonds and thus offers additional risk diversification.

Spread – The “Invisible” Costs of ETF Trading

The spread is the difference between the buy price (ask price) and the sell price (bid price) of an ETF on the stock exchange. It is, so to speak, a kind of "price premium" that the buyer pays when buying and which the seller accepts when selling.

A tight spread means that the buy and sell price are very close to each other. This is advantageous for investors, as the costs of buying and selling are low.
A wide spread means a larger difference, which leads to higher trading costs.

The spread can vary depending on the ETF, exchange, trading volume, and market conditions. The spread of an ETF is typically particularly attractive at times when the underlying securities of that ETF are also trading. For an ETF on American stocks, for example, this would be from 3:30 p.m. Swiss time. For retail investors, spread costs are often a significant part of the total cost of ETF trading, in addition to management fees. That's why it's worth paying attention to a tight spread when buying or selling, such as buying or selling at times of high trading activity.

An example to help you understand:

Assuming an ETF is traded at a bid price (sell price) of 100.00 euros and an ask price (buy price) of CHF 100.20, the spread is CHF 0.20 or 0.2%. If you buy the ETF at the ask price, the investor pays 0.20 euros more than the currently achievable selling price.

Recommendation for retail investors:

To keep spread costs as low as possible, investors should make sure to choose ETFs with high trading volumes and trade during periods of high stock market activity (usually during the main trading hours of the respective exchange). Limit orders can also help not to buy too much above the market price or to sell too low.

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