If you heard about ETFs, but don’t completely understand what they are and how they work, you’re at the right place. However, make sure to understand what market index, mutual funds, and index funds are first.
And if you’re new to this field, I’d recommend starting at the beginning and first and foremost understand what investing is.
That being said, if you’re reading this, I’m assuming that you digested the knowledge from the previous posts of the Become an Investor series and you’re ready to tackle the next topic.
What are ETFs?
Let’s start with breaking down the acronym first. Maybe it will answer more questions than only what it stands for.
ETF stands for Exchange Traded Fund. Exchange traded, as it suggests, means that it’s traded on a stock exchange (similar to stocks), and fund, again, as it suggests, means that it’s a fund (has similar characteristics such as those of mutual or index funds).
So basically, an ETF is a like a basket that holds stocks, bonds, currencies, commodities, or other underlying assets.
Most ETFs track the performance of an index that is tracking the underlying assets, similar to an index fund. And in many ways index tracking ETFs are quite similar to index funds (in terms of low costs, diversification, etc.), but at the same time they’re also quite different.
Difference between mutual funds and ETFs
Unlike index funds, which can be bought or sold at the end of a trading day for their NAV, the ETFs are traded on stock exchanges, just like stocks. Basically, although owning an ETF shouldn’t feel much different than owning an index fund, buying an ETF shouldn’t feel much different than buying a share in a company. This means that they don’t have a single price for the day, but their value may fluctuate during trading hours.
The larger ETFs (i.e. those who track the most commonly used indices such as the S&P 500), usually have low fees and high volume, so they are pretty liquid assets. That means that if you want, you can day-trade, buy on margin, or short ETFs, but doesn’t mean that you should. You’re becoming an investor, not a trader.
Accumulating VS distributing ETFs
Another characteristic specific to ETFs is the way they pay out their dividends. There may be multiple ETFs tracking the same index (or other underlying asset), with the same costs, but different way of handling the dividends. As the names suggest themselves:
- Distributing ETFs pay out the dividends in FIAT money
- Accumulating ETFs reinvest the dividends automatically
For example, the ETFs CSPX (iShares Core S&P 500 UCITS ETF (Acc)) and VUSA (Vanguard S&P 500 UCITS ETF) both track the S&P 500, but the one from iShares is an accumulating ETF and the one from Vanguard is a distributing ETF. Of course, this doesn’t mean that you would get “more money” by going one or the other way. Whether the dividend is paid out or not will be reflected in the price of the ETF, it’s just a preference whether you want it paid out in cash or automatically reinvested.
For the record, iShares also have a distributing ETF tracking the S&P 500, with the ticker symbol IUSA (iShares Core S&P 500 UCITS ETF (Dist)). Other ETFs that track the same index are IVV (iShares Core S&P 500 Index), VOO (Vanguard S&P 500 ETF), SPY (SPDR S&P 500 ETF), etc. I’m trying to convey that there are various options and you need to pick the one that makes sense for you.
And regarding your choice, in case you’re wondering which one is better (accumulating or distributing) – it depends. Basically it boils down to your preference and/or the tax implications regarding dividends in your country.
For example, if you’re just starting out (i.e. not planning to sell and won’t need the money in near future) and dividends are taxed higher than capital gains in your country, you might decide to go with an accumulating ETF. This is not a rule of thumb, but an example. Your specific situation needs specific evaluation, as it can depend on various other factors, such as: where is the company offering the ETF based, which country pays the dividends and whether the country has tax treaties with the country you live in, etc.
So, how to pick ETFs?
How to pick ETFs
When you request to see the details about a certain ETF, you’ll be presented with various fields. Similar to what we did with stocks, we’ll go through some of the components of an ETF quote. For example, you’ll be able to see the 3 month, YTD (year to date), 1 year, 3 year, and 5 year returns for the ETF, as well as its benchmark.
You’ll also see the distribution policy (Acc. vs Dist.), the distribution frequency (yearly, semi-annually, quarterly) and the yield (similar to stocks – the ratio between the annual per-share dividend and the ETF’s price).
Management fee and/or expense ratio is what you’ll need to pay close attention to as well – similar to mutual funds, all ETFs have a (small) annual management fee.
And lastly, you can see the shares outstanding and the volume (the number of trades during a period of time).
Actually, what I highlighted here are the most important details when choosing an ETF. Once you have an index in mind and a distribution policy of choice, it comes down to picking the ETF with the lowest TER (Total Expense Ratio). For any ETF tracking an index it will be a small percentage, but take your time to find the best one. In the previous post we already described how big of a difference can higher fees make on the long run, so have that in mind when picking your ETF. Basically, you can save thousands of dollars over the years by going with the cheapest option.
Just to help you understand the scale I’m talking about, the above mentioned VUSA has a TER of 0,07%. That means that on a portfolio of $100k, you’d pay 70$ fee.
Apart from the TER, the volume is also pretty important. If you find an ETF with minimal costs that nobody buys (maybe because it’s offered by an unreliable or less known company etc.), you’ll have a hard time selling the ETFs and thus liquidating your position. Going with one of the largest ETF providers can help you mitigate this risk. These include:
- BlackRock (managing iShares)
- Vanguard
- SPDR
- Charles Schwab
And a few more, but please make your own research by Googling “biggest ETF providers”.
Also, checkout the website JustETF. Go to the ETF Screener on the header and you can filter the ETFs by type (equity, bonds, commodity, real estate, etc.), region, country, sector, and much much more. It’s a really nice and easy way to compare your top picks instead of going to the websites of various providers and adapting to each one of their user interfaces… Unless you want to.
Summary of picking ETFs
Pick an index and a distribution type, and then choose a liquid ETF with the lowest TER.
Learning is much easier when you have a tight grasp on the fundamentals, isn’t it?
ETFs or Index Funds?
I said it before and I’ll say it again: it depends.
Assuming you’ve picked the most adequate ETF (low fees, high volume) and index fund for the asset allocation you have in mind, I’d say it boils down to one thing only.
Costs.
You’ve heard it before, no surprises there. However, this time I’m not talking about the management fees or the expense ratios of the funds. Investing in one or the other can have various additional costs, so make sure to take them into account. Let me give an example for each.
Let’s say you live in a country that is not the USA. If an index fund in your country tracks the S&P 500, then they’ll receive the dividends with the taxes withheld. Before they pay the dividends out to you, they’re obligated to withhold dividend tax based on your country’s tax system as well. This concept of is called a Tax Leakage and can be mitigated if your country of origin has a double tax treaty with the country of the underlying shares. Than either a percentage or the full amount can be recovered. Have in mind, I’m just describing the specific scenario when a person is not a US resident and invests in the US economy through a fund in his country. However, as previously said, every situation is different and needs adequate evaluation.
On the other hand, ETFs trade just like stocks, which means that you’ll need a brokerage account to be able to buy them. In your country of residence there will be a few banks that offer this service and, probably, a few online brokers that you can choose. You’ll have to do the comparison of both the annual brokerage fees and trading fees for each platform. If you’re based in The Netherlands, I could be more specific, so feel free to either contact me with specific questions or subscribe to receive a mail when I publish new posts – one of which eventually will be investing in The Netherlands. What I do is invest through DeGiro (no affiliation), as they have a list of commission free ETFs – which means that I only pay the TER of the ETF and nothing more.
If you’re living in EU you could also go the route of DeGiro, but I’d highly encourage you to do some research on your own as well.
Don’ forget, every platform (whether it’s a brokerage or a fund) will be more than happy to answer all your questions, so don’t withhold any.
Lastly, the recurring topic of taxes. As every country’s tax system is different, I’d suggest doing the following: prepare specific questions regarding dividend and capital gains taxes and contact the tax authorities or a tax adviser in your country. I called with the following question: “I’m living in The Netherlands and own ETFs domiciled in Ireland that track US companies. Should I pay dividend tax?”. The answer was no, because the dividends I receive are already taxed in the US. Note: if I went for the index fund route, than I’d receive dividends from a Dutch fund (not directly from the underlying companies), and thus I’d be a victim of double taxation.
Summary
ETFs are awesome.
And an advice: I’ve opened the black box of minimizing your expenses, but that doesn’t mean that you need to factor in absolutely everything before starting. Not that it’s detrimental to be completely aware, but it can cause “paralysis by analysis” if you get over ambitious. After you have your few good picks with high volume and low expense ratios, it may be better to just go with one instead of extending your research to cover black swans.
You can always reevaluate and/or adapt, but you can never start earlier.
By the way, a Black Swan is an event that comes as a surprise (is almost unpredictable and not expected) and has a major impact, but is rationalized in hindsight.
So try to skip considering what would happen if the dollar loses all its value, if EU falls apart, etc. Stick to comparing costs and understanding how capital gains and dividends are taxed in your country. Having skin in the game is often a better teacher than losing sleep investigating how to remove the factor of chance (luck).
So, don’t expose yourself to getting fooled by randomness and share this post if you caught the references.
See you in Part 6!
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