Financial Market & Products such as Stocks or ETFs explained simply

What are ETFs?


Anyone who researches investment opportunities will inevitably come across the abbreviation ETF. They are often referred to as the form of investment that everyone understands and that offers almost unlimited possibilities. In principle, however, every investment involves risks, and this naturally also applies to ETFs. You should therefore obtain detailed information about the product and understand it for every investment. This article is intended to help you with this when it comes to ETFs.

What exactly is an ETF?

However, it is not quite as simple as it looks at first glance. The abbreviation ETF stands for "Exchange Traded Funds". This describes more clearly what an ETF actually is. For less experienced investors, however, the term raises more questions than it answers. So let's take a closer look.

What financial products does an ETF invest in?

An ETF replicates a specific index on a one-to-one basis. In many cases, this is an equity index, such as the German benchmark index DAX (German 40) or the English FTSE 100, or a bond index. An ETF that replicates an equity index therefore develops in line with the performance of the respective index. This in turn develops in line with the price performance of the stocks it contains according to their weighting in the index. A stock with a high weighting has a greater impact on the performance of the index than a stock with a low weighting. In short, an investment in an ETF is an investment in the price performance of all the stocks included in the index.

Do investors buy stocks with an ETF?

The answer to this is no. Anyone who invests in an ETF, or exchange-traded index fund, is investing in this fund, not directly in the assets it contains. However, depending on the type of ETF, you may be entitled to receive dividends. But even with an ETF, it is not always the case that all stocks are bought in proportion to their share in the respective index. A distinction is made between the physical ETF and the synthetic ETF.

  • A physical ETF actually buys the stocks that are included in the index it tracks. This applies at least if it is not a very large index. The US S&P 500, for example, contains the stocks of the 500 largest listed US companies. A one-to-one mapping of this index is correspondingly complex. For this reason, a selection is often made for these indices for an ETF, in which the stocks of the companies that have the strongest influence on the performance of the index are included. The selection is optimised in such a way that the stocks can replicate the index performance almost identically. The physical ETF is considered to be the more transparent form, as it is relatively easy to understand which assets are being invested in, even for less experienced investors.
  • A synthetic ETF, on the other hand, does not buy the stocks contained in the index. In this case, the index is usually replicated via swap contracts with a financial institution. One advantage of synthetic ETFs is the lower costs. The main costs are associated with the conclusion of the swap contracts with the financial institution, whereas a physical ETF incurs transaction costs for the purchase and sale of shares when the composition is adjusted. Overall, the total costs are usually lower for synthetic ETFs.

It should be noted that the composition of synthetic ETFs is usually more difficult to understand for less experienced retail investors. They are often used to gain access to markets that are normally closed to retail investors. These can be stock markets, for example, to which foreign retail investors do not have access.

Do you receive dividends with an ETF?

Whether an investor in an ETF receives dividends for the stocks contained in the fund depends on the type of ETF. Firstly, the assets contained must pay dividends. If a dividend is distributed for a share in the ETF, then investors in this ETF are of course also entitled to this dividend on a pro rata basis. Whether this is paid out directly to the investor depends on whether it is a distributing ETF or a reinvesting ETF.

  • Distributing ETFs, as the name suggests, distribute dividends received from the stocks they hold to investors. It goes without saying that stocks whose companies generate profits and pay a dividend can pay the dividend pro rata to the investors in the ETF. If a company does not pay a dividend to the shareholders, none can be paid to the investors in the ETF.
  • Reinvesting ETFs, also known as accumulating EFTs, do not distribute the dividends paid out directly to investors. Instead, the fund manager buys additional stocks for the fund for the capital received, which increases the value of the fund, and therefore the value of the units in the fund, accordingly.

Which type of ETF should be chosen?

Which type of ETF is the right product for an investor ultimately depends on their individual investment objectives. What meets the objectives of one investor may contradict those of another.

Investors who opt for an accumulating ETF will see their units grow in value through the reinvestment of dividends paid out. They practically benefit from the compounding effect of their investment and do not have to worry about reinvesting the money paid out.

If an investor opts for a distributing ETF, the dividends paid out to the fund are credited to him as a cash amount. They can therefore decide for themselves whether to use the amount from the dividend for further investments or for personal use. In principle, however, an investor receives the same amount of the corresponding dividend in both forms of ETF. Either as additional shares in the ETF or as a cash amount.


Is investing in an ETF a good idea?

This answer also depends on an investor's investment objectives. In addition to the investment objectives, an investor should first be aware of the general advantages and disadvantages of investing in an ETF. If these are convincing to the investor, it is then necessary to weigh up the risks of the specific ETF in which he intends to invest. When making this decision, it is certainly helpful that ETFs are relatively easy to understand products. They track a specific index on a one-to-one basis and its history can usually be easily traced and assessed. Even if historical results are of course not a reliable indicator of future performance, they provide an overview of the possible performance stability. In principle, however, an ETF should not be seen as a short-term investment, but as a long-term investment.

What are the advantages of an ETF?

An ETF is an excellent instrument for making broadly diversified investments in the stock market. This significantly reduces the risks compared to trading in individual stocks. In addition, investing in an ETF involves relatively little effort compared to buying individual stocks and the composition of the securities it contains is transparent for the investor, as it corresponds to the index it tracks. The fact that many investors are able to buy shares in an ETF with very small amounts is another advantage that should not be ignored.

What are the disadvantages of an ETF?

Firstly, the investor has no influence on which individual stocks an ETF invests in. For example, if the index being tracked consists largely of stocks from a particular industry, as is the case with the Nasdaq, prices could plummet if this industry gets into difficulties due to economic developments. The same applies if a large share comes from a particular economy, for example the eurozone or the USA, and this economy slips into a recession. In both cases, the negative impact on the corresponding index, and therefore on the ETF, would be relatively large.

Do I have to pay tax on income from ETFs?

Whether and which taxes have to be paid on the income from ETFs depends on the investor's country of residence. As a rule of thumb, however, where income from capital investments is subject to tax, this also applies to income from ETFs. Anyone who is unsure about the type of taxation in their country of residence should always seek professional advice. 


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