What is an ETF, how it works and one example analyzed

We are at the point of our journey where we should think about how to invest our money. We did a spending review to understand our expenses, saved some money to have some peace of mind, we thought about our goal (motive + time frame) and calculated how much we need to invest every month to reach it. Last but not least, we decided to go for Passive Investing.


So, how do we bring this finally to reality?


The main instrument of passive investing is to buy Exchange-Traded funds (ETF). According to Investopedia, an ETF "is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same way a regular stock can."


Let´s say you believe the US economy will perform well in the future and would like to profit from the growth of the S&P 500. To match that without making any bet on single companies, you would need to buy the stocks of each and every company listed there and then spend time balancing them based on the fluctuations of their market capitalization. This is very time consuming and absolutely inefficient for a single investor, so you can buy an ETF that tracks the S&P 500 and are done with it. Of course, you pay for this convenience - more on that below. 


There are many different ETFs and they can track also different type of assets: stocks, bonds, precious metals, real estate. I have experience with ETFs focused on stocks and bonds, but now I fully focused on stock-based ETFs as the bond ones where offering very little returns. That might change in the future of course (see disclaimer at the end of this blog). 


So, when choosing an ETF, you should pay attention to a few aspects:

  • Total Expense Ratio (TER) - measures the total cost of a fund to the person purchasing the ETF. It is expressed in % and basically reflects the cost of keeping the ETF in line with the underlying index (plus some profit for the issuer of the ETF)
  • Accumulating vs Distributing ETF - a distributing ETF pays out all dividends while an accumulating ETF reinvests that income back into the fund
  • Dividend Yield - measures the dividends distributed over a year relative to the value of the ETF. It is expressed as %
  • Fund Size - how big is the fund itself. Investing in an ETF too small may lead to liquidity problems when you try to sell it later on, as there is just no demand for it. A good rule of thumb is to look for a fund size of at least >100 mln
  • Replication Method - there are several ways to replicate the performance of the underlying index. The standard one is to buy exactly all the different securieties that make up the index (full replication), but this is not always possible. Then you could buy a sample of the index (sampling) or use complex financial derivaties to synthetically replicate the index (synthetic replication). In general, I would always strive for physical replication

A great website to find ETFs and their key data is: www.justetf.com. This website has a search function where you can find tons of ETF based on your specific interests (e.g. Energy, Emerging Markets, ect). 


Let´s go through one example together. This is an ETF I actually have in my portfolio - iShares Global Clean Energy UCITS ETF. Go to www.justetf.com, copy paste the name of the ETF and click on it among the search results. Next, click on the Factsheet EN link just under the brief introduction of the ETF.


The Table with key facts already shows a lot of the key information we discussed above:


First of all, the table shows the asset class is Equity and the main currency is US Dollars. 


The underlying benchmark is listed also in this prospect - in this case S&P Global Clean Energy Index.


TER is expressed as Total Expense Ratio and is 0.65%.


Dividends are distributed (not accumulated) - see the last line before the break - every 6 months. The Dividend Yield (Distribution Yield here) is 0.75% and dividents are distributed twice a year. 


The replication method (product structure here) is physical.  


The ETF holds 76 Equities. 


If you had invested 10,000 USD since the creation of the ETF, you would have lost quite some money! You can see how in 2008 the value plunged and has not recovered yet fully. 

Also, here it is important to see how the fund is tracking the benchmark. Ideally, the two lines should be as close as possible. 

Here you can see the top companies that make up the ETF and in which percentage. If you are familiar with the industry you will recognize some names like First Solar and Vestas Wind Systems.

This shows the sector breakdown, in this case around 50% of the holdings are from Utilities companies. This ETF is specialized in Clean Energy, so there are very little surprises here but if you look into a broader ETF you will find a much longer list of sectors. 

Last but not least, the geographical breakdown of the total holdings. In this case, we are skewed towards the US, New Zealand, Denmark and China. Combined, they make more than 60% of the total holding value.

The format in which this info is shared can differ depending on the issuer of the EZF (e.g. Vanguard vs iShares) but you will be able to find most of them easily in every factsheet.


In the next blog, we will look at some options to create a global ETF portfolio with minimum hassle.


I am not a professional investor and that nothing contained in this blog should be construed as investment advice. Any reference to an investment's past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.

Write a comment

Comments: 0