In recent years, ETFs have grown exponentially in popularity. In 2020, ETFs passed the symbolic mark of 1,000 billion euros of assets under European management. However, before investing in ETFs, you must understand how they work. You will find everything you need to know in our guide!
What is an ETF?
ETF stands for Exchange Traded Funds. As the name implies, they are index funds traded on an exchange. ETFs track the performance of stock market indexes, thus combining the performances of several companies—unlike individual stocks, which represent the performance of a single company each time. The objective of an ETF is to achieve the same return as the index it tracks.
Passive investing, therefore, means betting on the market’s overall growth. Rather than manually selecting individual stocks, you trust the economy’s growth over time. For example, if the CAC 40 rises by 1%, then the value of a CAC 40 ETF will also rise by 1%. If it falls in value, so will the ETF. Those who invest in an ETF are therefore betting on an established market rather than on buying individual company shares, as an active investor might do.
It has been shown that building long-term wealth through a passive strategy, such as a buy-and-hold strategy with ETFs, is more efficient than active approaches. ETFs are also much cheaper than actively managed funds. In the case of active funds, the managers are in charge and manually manage the fund’s composition (stock picking); management fees are therefore higher. So how do ETFs work, and how do you choose them? This is what we will see throughout this guide.
Who issues ETFs?
ETFs are offered by asset management companies. On a global scale, there are thousands of different ETFs, of which more than 750 are listed on the Paris stock exchange. This multiplicity is explained by the large number of management companies that issue ETFs and the countless indices that partly reflect specific strategies or replicate niche sectors. First, the management company buys the securities contained in the index with investors’ contributions. It then issues a security (an ETF) that tracks the performance of all these securities.
How does an ETF replicate its index?
Let’s use the CAC 40 as a simple example of how ETFs work. The CAC 40 index comprises 40 French stocks selected from the 100 largest capitalizations. The CAC 40 ETF replicates these 40 stocks with weights similar to their weights in the index. Therefore, through an ETF, you can bet on the evolution of the CAC 40 without directly buying each of the 40 stocks that make it up!
What would still be possible for the CAC40 is much less so if we take a global index composed of thousands of different stocks. The ETF, therefore, buys all the stocks that make up its benchmark index, taking care to respect their respective weightings. Thus, when new stocks enter the index, the ETF buys them; when stocks leave the index, it sells them. Unlike active funds, this process is fully automated and does not require a manager’s intervention.
An ETF is an investment fund; like any investment fund, the custody of the assets and their management are separate. If the issuing management company goes bankrupt, the assets that make up the fund are kept separately by a custodian and will not be affected. So you don’t have to worry about your money.
Different replication methods
The way an ETF replicates the performance of a set of individual stocks is called the replication method. This directly impacts the cost, performance, and risk of your ETF. There are three different methods:
- Direct or physical (total) replication (almost): all stocks in the index are bought individually. This is considered the most accurate method. However, physical replication can be somewhat more expensive for ETFs with hundreds or thousands of stocks.
- Partial physical replication or sampling (optimized): the ETF provider performs a pre-selection and physically buys only those liquid stocks deemed to have a sufficiently large weight in the index. This method is particularly suitable for broad ETFs whose performance is mainly driven by a few large representative stocks.
- Indirect or synthetic replication (swap ETF): the ETF provider replicates the index through a swap with a counterparty, often an investment bank. The latter guarantees the index return to the ETF management company in exchange for the actual return of a reference portfolio. This replication is particularly suitable for niche and commodity markets.