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ETFs: Basic Elements to Know Before Investing
Increasingly popular among French investors are ETFs (or trackers), which are investment funds that trade on the stock exchange like stocks and make it easy to diversify your portfolio.
However, with several thousand ETFs listed on European exchanges, choosing which ETF to invest in can quickly become a real headache.
In this article, we will see the main elements that you need to check and learn before investing in an ETF.
The underlying asset in which the ETF is invested
ETFs can replicate (physically or synthetically) many underlying instruments, such as major stock indices, as well as thematic stock portfolios, commodity baskets, bond portfolios, and even cryptocurrencies.
It can also be a hybrid risk ETF (stocks + bonds).
It is all the more important to check the composition of an ETF before investing, because it happens that a “renewable energy” ETF is invested not only in companies in the renewable energy sector, but also in other related sectors.
There are many ETF issuers. Among the most famous are BlackRock, Amundi, Vanguard, Invesco, Xtrackers, State Street and even Franklin Templeton.
There are also newer issuers such as HANetf, RizeETF, Mellanion Capital, 21Shares.
While all ETF issuers are subject to the same rules and obligations, it is important to ensure that the ETF issuer is sound and not at risk of bankruptcy.
Many investors mistakenly place a lot of value on the amount of assets under management (AUM) in an ETF. It’s true that an ETF with hundreds of billions of dollars of assets under management can inspire confidence.
However, the size of the AUM ETF is not an important consideration since ETFs are open-ended funds. Assuming an investor wants to invest 10 million euros in an ETF with only 10,000 euros in assets under management… the issuer can create as many new securities as needed to satisfy the investor’s demand. The only real limitation concerns the liquidity of the underlying asset. If the underlying asset is the S&P500, the true liquidity constraint is equivalent to the liquidity of the S&P500.
However, it may be appropriate to check daily volumes. Low volumes can mean higher spreads for market buying and selling.
ETF management fees (TFE or TER) range from 0.10% to 0.90% per annum. Fees are included in the ETF valuation.
Index ETFs that track the performance of the S&P 500, Nasdaq 100, DAX, CAC 40, or other major equity indices tend to be the cheapest in terms of fees (between 0.10% and 0.25%).
ETF management fees are indexed based on the complexity of the product. Thus, a thematic or SRI/ESG ETF will have a higher management fee than an index ETF due to the analytical work done by the manager to select the stocks that make up the fund. Conversely, an index ETF requires less work on the part of the manager, as it simply replicates the composition of the stock market index.
ETFs with the highest fees (>1%) are complex ETFs that require day-to-day management or incur transaction costs for the issuer. These include “actively managed” ETFs and short leveraged ETFs.
More astutely than dwelling strictly on the amount of ETF management fees, it is necessary to compare the amount of fees with the results achieved.
Before you start talking about ETF performance, remember that past performance is not an indicator of future performance.
In this chapter, we will exclude leveraged and inverse ETFs as they are complex products whose performance is calculated on a daily basis, which includes beta slippage.
We will also exclude “actively managed” ETFs, as well as thematic ETFs, whose performance is highly dependent on the performance of the manager.
So let’s focus on index ETFs, which can perform differently than the index they replicate. Then we talk about “tracking errors” when the return of the ETF differs from the return of the index.
It is better to choose an index ETF that has low or no tracking error.
Some sites report performance differences.
Dividend distribution policy
When it comes to processing dividends in ETFs, there are two types of ETFs:
This type of ETF will share and pay investors cash dividends received by the fund. Payments can be made monthly, quarterly or annually. This type of ETF is ideal for investors who need regular income.
ETFs are capitalized
This type of ETF will reinvest dividends received to buy more shares. For long-term investors, this type of ETF will benefit from a compounding effect that can increase returns tenfold.
ETF eligibility for PEA
The same eligibility criteria as for UCITS will determine if an ETF is eligible for PEA.
As a reminder, at least 75% of the fund must be invested in PEA eligible stocks, i.e. shares of companies headquartered in a Member State of the European Union.
ETFs have a feature that makes it possible to have PEA eligible ETFs when they are invested in overseas markets (US, Asia, etc.). This is possible thanks to a hybrid replication mode that physically reproduces European shares and synthetically reproduces foreign shares. As such, the ETF continues to be predominantly invested in Europe, providing access to other markets.
In conclusion, although ETFs are financial products that make investing in the stock market easier and more democratizing, you should not be in a hurry to buy an ETF and you should do a few checks beforehand. When in doubt, most ETF issuers have a team of advisors available to answer your questions… So feel free to reach out to them!