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ETFs simply explained
What are ETFs, how do they work and what are their benefits? Find out everything you need to know about this kind of investment funds now.
Content:
Exchange-Traded Fund (ETF) is the term for funds traded on the stock exchange. Each ETF partially or fully tracks a stock market index. An index in turn comprises the performance of a specific investment portfolio and is therefore a barometer for a defined market. This defined market can consist of various companies, countries, industries or raw materials (such as gold or silver). Investing in ETFs gives investors the opportunity to participate in the performance of individual markets and thus increase their assets.
ETFs can be managed both actively and passively, with many being managed passively – i.e., automated by software. In contrast to active funds, there is little or no work involved for fund managers. As a result, many passive ETFs cost investors less than actively managed forms of investment. Automatic management also ensures that the corresponding index (e.g. Swiss Market Index, SMI) is ideally represented one-to-one, resulting in only minor differences between the index and the ETF.
In contrast to ETFs, traditional investment funds are generally actively managed and aim to achieve a higher return than their benchmark index by buying and selling individual securities. Fund management usually incurs costs for ongoing analysis and sometimes reallocation.
ETFs first appeared on the market in Switzerland in the year 2000. As early as 2005, the global investment volume of ETFs listed worldwide amounted to USD 417 billion (CHF 368 billion). By the end of 2023, invested assets had already exceeded USD 11 trillion (CHF 9.7 trillion). While initially only stock indices were covered, other asset classes such as commodities, real estate and bonds were gradually added. Over time, some ETFs have tracked an index more and more broadly, and ETFs are constantly evolving.
ETFs always track the performance of an underlying index as closely as possible. With an ETF, investors buy small shares of the companies that are represented in an index. If the index gains overall, investors also gain. If it loses, they lose accordingly. The index serves as a preselection, making it easier for investors to put together a portfolio. Nevertheless, they should always know exactly how an investment fund is composed.
Most ETFs are made up of different companies from various industries and several countries. It is also possible to invest in precious metals or digital currencies. The mix varies from fund to fund. The۶Ƶ SMIM® ETF CHF dis, for example, invests in all stocks that are included in the SMIM® SMI Mid Index. The weighting of the respective stocks in the ETF corresponds to the weighting of the index. If the ۶Ƶ share accounts for around 6%, ۶Ƶ also accounts for 6% of the ETF mentioned.
As an investor, you can choose between ETFs with different focuses. Before investing, you should therefore always ask yourself which sectors, companies or countries are not suitable for you and which you prefer.
ETFs are securities that are traded on the stock exchange like stocks. This means you can buy or sell ETFs during official trading hours. The ETF prices change continuously, just like the prices of the respective index. For example, if the Swiss Market Index rises by 12.5%, the ETF typically also gains by 12.5%. The same applies to negative fluctuations.
If you want to invest in ETFs, you can invest in professionally managed ETFs, for example through the digital platform ۶Ƶ key4 smart investing. To buy ETFs, you must first open a securities account. You can then personally select the ETFs you want and purchase them proportionally. You can view the prices of the ETFs in your Mobile Banking or E-Banking, and you can also sell them at any time.
An ETF aims to track (replicate) the underlying index as accurately as possible. A distinction is made between “physical” and “synthetic” replication.
Physical
The classic method is physical replication, whereby the ETF portfolio contains all index securities (shares) with exactly the same weighting as in the index. This is especially true of small indices. A variant of physical replication is optimized replication. In this approach, not all shares of the actual index are acquired, but only a portion. The method is used in particular when an index contains a large number of securities that are difficult to trade and whose trading would incur correspondingly high costs.
Synthetic
ETFs that apply synthetic replication enter into a so-called “swap” agreement with a counterparty. Earnings and fluctuations in the value of the underlying financial instrument (in the case of the ETF, the index) are exchanged for corresponding payments. This creates a mutual obligation between the ETF and the counterparty: The ETF delivers to the counterparty either the return of an asset portfolio it holds or the equivalent cash value. The counterparty, in turn, provides collateral – both for the index performance and to hedge the default risk.
Even with high transparency and diversification, ETFs, like any investment instrument, are exposed to risks. This makes it all the more important that you know the most common ones.
The tracking risk is the difference between the ETF return and the index return at the end of a specific observation period. For example: Over the past five years, an ETF has an annualized standard deviation of 0.02%. This means that it has tracked the index with only a small deviation. This percentage deviation is referred to as the “tracking error”. The greater this is, the less reliably the index is tracked by the ETF.
It is important to note that the “tracking difference” always reflects past periods. The future performance of the ETF cannot be derived from it.
Classic ETFs, such as the ۶Ƶ ETF (CH) SMI, are liquid. This means you can buy or sell this exchange-traded fund at any time during official trading hours.
Liquidity risk can arise if the ETF contains niche products – such as unusual shares – for which there is not enough demand. A liquidity risk also arises if a market crisis occurs and many investors want to sell at the same time. If purchases do not counterbalance this, the investment may be jeopardized.
By investing in ETFs, you benefit from diversification, as each ETF tracks an entire market. However, this can also become a disadvantage. For example, geopolitical or economic events can have a strong negative impact on a market and also on the ETF.
Market risk exists with every investment – regardless of the form – because investing always takes place in a market environment. This is why it is so important to build up a certain basic knowledge of economic and geopolitical movements or to seek expert support.
By preselecting and diversifying, ETFs already do some of the work for you. Nonetheless, you should never invest in mutual funds without careful consideration. To achieve your investment goal, you should work with a financial specialist to develop an investment strategy that suits your investor profile. Your strategy can be both long-term and short-term and should be adapted to your life situation.
۶Ƶ key4 smart investing helps you define the right strategy and select the right ETFs for you. You can buy ETFs starting from CHF 50 or set up a monthly ETF savings plan – all from the comfort of your smartphone or computer.
ETFs are investment instruments that are generally cost-efficient, flexible, transparent and liquid. Because traditional ETFs track a selected index, as an investor you are effectively buying the index equivalent. With just one transaction, you are already diversified. If you also want to invest in ETFs, you should know the composition of the respective ETF, the risks involved and whether it fits your investment strategy.
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