What are ETFs and how to trade them

In recent years, Exchange Traded Funds have become increasingly popular as an investment product. The funds known by their abbreviation ETF do not require active management and instead track stock market indices one-to-one.

The advantage of this construction: ETFs are extremely inexpensive. Products based on standard price barometers charge less than 0.3 per cent per year. This is far removed from the costs of actively managed funds. For the management of equity portfolios, they call up 1.5 to 2 per cent per annum, sometimes even more.

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The front-end load, which can be due for actively managed funds, also does not apply to ETFs, as these are traded on the stock exchange. Only the transaction fees and the difference between the purchase price and the selling price (spread) need to be kept in mind on the cost side. Around 1,400 ETFs are available on the Frankfurt Stock Exchange alone. They track several hundred indices. But which is the right one for your own portfolio?

Price barometers such as the Dow Jones for US equities, the Euro Stoxx 50 and the DAX are widely known. They are also available to everyone via ETF. However, there are often alternatives that are less in the limelight but are much better suited as investment targets.

Diversification is key

It is not very helpful when selecting the best index to look only at the return. Because this view goes into the past, and already in the coming year, the performance of a price barometer can look completely different.
Whether an index is suitable for forming the basis of a portfolio is decided elsewhere. A good price barometer fulfils an important requirement: it invests widely. Because only sufficient diversification spreads the risk over many shoulders and increases stability, ideally, an index should contain several hundred stocks and offer a balanced mix of sectors and countries. Cluster risks can thus be avoided.

Costs and size are crucial

Of course, the product side is also important: it doesn’t help if you have tracked down a good index, but the corresponding ETF has weaknesses. For this reason, the editors present a recommendable ETF for each of the indices analysed.

also important: it doesn’t help if you have tracked down a good index, but the corresponding ETF has weaknesses. For this reason, the editors present a recommendable ETF for each of the indices analysed.

Investors often have the choice, as many price barometers are offered by several companies via ETF. Then a handful of criteria will help you make your decision. Running costs, which should be as low as possible, play an important role in choosing the best product. In addition, the ETF should not be too small to reduce the risk of being removed from the programme. In addition, large ETFs are usually more readily available on the exchange, which minimises the price difference between buying and selling.
Long-term investors, in particular, should also be careful to buy accumulating ETFs that reinvest income such as interest and dividends in the fund’s assets. This makes the compound interest effect particularly noticeable when saving and eliminates the need for laborious personal reinvestment.

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The largest stock market in the world affords itself one of the most unusual benchmark indices. Although the Dow Jones is extremely important, investors are better off switching to alternatives with their ETFs.

One may think what one wants of the USA or President Donald Trump in particular. The fact is, however, that US stocks belong in a broad portfolio of equities. The USA is not only the strongest economy in the world but also by far the largest stock market. Around 4,400 companies are listed on US stock exchanges, with a market capitalisation of more than 27 trillion euros.

If you want to find out about the state of the US stock market, you will often come across three price barometers. The Dow Jones Industrial Average as well as the Nasdaq 100, abbreviated to Dow Jones and Nasdaq, are quoted particularly often. The S & P 500 also appears regularly. The MSCI USA is rarely mentioned as an index.

As far as age and dignity are concerned, nothing comes close to the Dow Jones Industrial Average. It is one of the oldest price barometers in the world and was founded in 1896 by Charles Dow and Edward Jones, the founders of the Wall Street Journal.

Its composition has changed completely over the past 123 years. Today, the index includes 30 stocks that are among the most important companies in the USA.

This is the first peculiarity of the Dow Jones Index. The 30 stocks do not necessarily have to be the 30 largest US companies. In particular, the Internet giants Amazon, Facebook and Alphabet, which are among the five largest companies in the country, are missing from the price barometer. Rather, the composition of the Dow Jones Industrial Average is based on history. Preference is given to traditional companies that have been able to hold their own in the market for a long time. The publishers of the “Wall Street Journal” still decide today which corporations these are. There are no fixed rules on composition – the second peculiarity.

The third peculiarity concerns the calculation method. It is not the market value that is decisive for the weight of a share, but its price. Stocks with high quotations, therefore, have a stronger influence on the index than stocks with low prices.

All this makes the Dow Jones not only one of the oldest price barometers in the world but also one of the most unusual. By contrast, the two much broader US stock indices S & P 500 and MSCI USA follow firm rules. As is customary today, they weight their stocks according to market capitalisation, i.e. the total value of all the shares in a company. The weighting of the individual sectors is almost identical. The information technology sector clearly sets the tone, and stocks from the healthcare and finance sectors are also strongly represented. However, the number of stocks in the MSCI USA is somewhat higher: 643 companies are represented, while the S & P counterpart has 500.

As venerable as the Dow Jones Industrial Average may be, its importance as an indicator of the US markets is great: it is not suitable as a basic investment. The almost bizarre construction is one counter-argument, its low dispersion the other, which weighs even more heavily. Their broad diversification, on the other hand, makes the S & P 500 and the MSCI USA very good basic investments for the US equity market. The MSCI USA can use its slightly higher number of stocks as a plus point, while the S & P 500 can use its higher profile, which has led to some very liquid products on this index.

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The Nasdaq 100, which contains the 100 most important technology companies, is not suitable as a basic investment. The number of stocks is large enough to ensure an acceptable spread. However, the restriction to individual sectors does not meet the requirements for broad diversification. In addition, the dose of technology stocks is also high in the market-wide indices, so that many investors are likely to be well served.

Europe: Buying the whole continent

The most common price barometer for the European stock market is the Euro Stoxx 50, but for investors, there are more suitable indices that put the investment on a more stable footing.

The Euro Stoxx 50 index contains the 50 largest companies in the eurozone.
However, the Euro Stoxx 50 is rather unsuitable for investments in shares of the domestic continent. It reflects the development of only 50 stocks – too little to guarantee sufficient diversification.

The weighting of countries also reveals cluster risks. French and German equities together account for around 70 per cent of the index and therefore dominate strongly. Spain and the Netherlands each account for just ten per cent, while all other countries play only a subordinate role.

The MSCI Europe gives a much better picture. It is made up of 442 stocks and extends the investment horizon to the whole of Europe. In addition to the eurozone countries, Great Britain and Switzerland are also represented in the price barometer. Both countries then immediately make up a large share: Great Britain 27 per cent, Switzerland 15 per cent. The larger number of stocks and the broader regional positioning ensure a much better diversification than with the Euro Stoxx 50. In addition, the British pound and the Swiss franc make two non-euro currencies relevant. This also increases the spread.

The composition of the Stoxx Europe 600 is not much different. Its weighting of the different sectors and countries is similar to that of the MSCI Europe. However, the Stoxx index contains 600 stocks, which is about a third more companies than the MSCI price barometer.

The three positions with the highest weight are identical for both indices. On the podium are three Swiss companies: the food manufacturer Nestlé and the pharmaceutical companies Novartis and Roche.

Both the MSCI Europe and the Stoxx Europe 600 are suitable for investors who wish to invest widely diversified in European equities. ETFs on the Euro Stoxx 50 are, on the other hand, not suitable as a deposit base for European stocks. Only investors who do not want to accept any foreign currencies should consider entering the market.

Owning the world

More than 1,500 stocks are invested in indices that reflect the global stock market. Investors entering the market must be aware of the dominance of US stocks. Price barometers, which reflect the development of the stock markets, are available not only for individual countries or regions but also for the whole world.

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The best known global index is the MSCI World. It contains more than 1,600 stocks. Its name, however, is somewhat misleading, as only industrialised countries are taken into account. These include the USA, Japan, Hong Kong and Singapore in Asia, many Western European countries and Australia.
The weighting of the sectors in the MSCI World is reasonably balanced. Although most stocks come from the IT and finance sectors, their share is not overwhelming.

The situation is quite different for the countries: Here, the dominance of the USA is blatant. Almost 63 per cent of the stock market value in the MSCI World comes from the United States. What looks like a construction error of the index is rather a reflection of reality: the USA is by far the largest stock market in the world. An index like the MSCI World, which includes all industrialised countries worldwide and is based on the stock market value, cannot help but weight the index as it is.

More countries, less America

The US share in the MSCI All Country World Index (ACWI) is still high, but still noticeably lower. The ACWI claims to be a true world index. It also includes emerging markets such as China, India and Brazil. However, investors hoping for a balanced mix of developed and emerging economies will be disappointed. Emerging markets contribute only around ten per cent to the index. A total of slightly more than 2,800 equities are included.

In terms of sectors, there are only slight differences between the two price barometers. Banks, insurance companies and other financial institutions are weighted slightly higher in the MSCI ACWI, while the healthcare sector is weighted slightly lower. This trend applies all the more to the third global index, the FTSE All-World. Shares from the financial sector have an even higher share, shares from the health sector a smaller share. In addition, the US share is lower than in the MSCI ACWI. With 3,200 stocks, it is the broadest of the three world indices presented here.

In terms of diversification, the two more comprehensive price barometers are preferable. Not only do they contain more equities, but they are also regionally more diverse. Compared to the MSCI ACWI, the FTSE All-World scored a points win thanks to its even broader diversification. The fact that the US share is lower there than in the MSCI World should be seen as an advantage rather than a disadvantage by investors looking for basic global investment.

The dominance of the US equity market has been enormous in recent years. As a result, the US has a weight in the MSCI World that is significantly higher than its economic strength suggests. Therefore, the MSCI ACWI and the FTSE All-World are fundamentally better diversified.

Riskier but also interesting are ETFs that are tracking emerging markets only. These include the Vanguard FTSE Emerging Markets ETF or the iShares Core MSCI Emerging Markets ETF.

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