How do ETFs work? What you really need to know to get started!

ETFs, or exchange-traded funds, have been gaining in popularity in recent years as investors seek low-cost, diversified investment options. I’m sure you’ve come across ETFs, when researching about investing and finances. But what are ETFs, exactly, and how do they work? In this article, I will cover all the basics on ETFs. You will find out what they are and why they are a great investment tool for beginners. We will cover the advantages and disadvantages of ETFs, how to choose the right ETF for your portfolio, and how to get started with investing in them. Whether you are a seasoned investor or just starting out: Read on for everything you really need to know on ETFs.

Table of contents

• ETFs 1:1 – What you need to know
• Advantages and Disadvantages of ETFs
• Choosing the Right ETF
• Getting Started with ETFs in Switzerland
• The One Thing You Need to Remember About ETFs

ETFs 1:1 – What you need to know

ETF stands for exchange-traded funds, which sounds way more complicated than it really is! A fund is a collection of stocks, bonds or other assets. This fund can be traded (bought and sold) in two different ways. Firstly, “over the counter” being bank internal, or secondly publicly via a stock exchange. Thus the word exchanged-traded fund. There are ETFs that invest in particular industries, regions or commodities. This article focuses on index-based ETFs (passive funds) which are designed to mirror the performance of a specific market index (like the S&P 500 being the 500 biggest US stock companies). If you want to find out more about active funds and why they underperform index funds, check out this article.

When investing in an ETF, you are essentially buying a small piece of every asset held by the fund. Let’s take the MSCI World for example, which is one of the most known ETFs. The ETF contains over 1500 companies, the top 10 companies being:

By buying the ETF, you are investing into all 1500 companies in the fund. You are automatically diversifying across multiple companies, currencies, regions, industries, ect. (see image below), which reduces your risk. 

Source: MSCI.com 

ETFs have become increasingly popular, because they are less pricey than active funds and make it easy to diversify your portfolio. You don’t need to do intense market analysis or go through a large list of companies, but instead you can pick a small handful of  ETFs to invest in (one All-world ETF can also do the job). With highly diversified ETFs that replicate the overall market, the risk of an investment failure is reduced significantly (find out more about that in this article). 

ETFs have become the cornerstone of passive investing: A strategy where you invest in a broad range of stocks through ETFs to match the performance of a market index rather than trying to beat the market. This approach typically involves buying and holding low-cost ETFs over the long term. It requires minimal buying and selling, making it a simple, cost-effective, and low-maintenance way to grow your investments gradually. The idea is to let your money grow with the market over time, without the need for frequent trading or active management.

Want to learn more about the RULES OF INVESTING? Download my FREE guide! 👇🏼

ETFs are created by a financial institution such as UBS, Vanguard or iShares by BlackRock and are assigned a specific investment objective. For example, some ETFs only include companies valued at a certain number, from a specific region or certain environmental criteria. 

Advantages and Disadvantages of ETFs

As with everything in life, there are advantages and disadvantages of ETFs. For me personally, the advantages outweigh the disadvantages, and I will tell you why:

1. ETFs are a great investment tool because they have low fees (between 0.05% and 0.25%). ETFs are passive funds that don’t need to be managed by expensive fund managers resulting in more money in your pocket. As a comparison: Fees of actively managed funds range between 1.5% and 5%!
2. Also, you save on trading costs. Every time you buy or sell a stock or ETF, you incur trading costs with your broker. By investing in for example the MSCI World ETF you make one trade instead of 1’500 trades to buy every single company stock separately.
3. Diversification is key - as you’ll likely already know. ETFs help you diversify your portfolio in the cheapest and fastest way. If you were to invest into only one ETF, you are still diversifying. That means you don’t have to select a large number of investment options. However, always check how many positions (thus companies or assets) the ETF holds.
4. Tax efficiency: Private individuals selling stocks and realizing capital gains don’t pay taxes on these gains in Switzerland. That is a major benefit compared to our neighboring countries that get taxed at 30,5% (Germany) and 30% (France) fee slapped on their capital gains. However, dividends are considered income and thus taxable. 
5. Some would argue the lack of self-control for the investor is a disadvantage, but I don’t agree. Your mind can be your biggest roadblock on your journey to financial freedom – ETFs help you control it. You won’t have time to track the performance of every company in an ETF.  Just invest and let it be. 

Choosing the Right ETF

Once you have decided to invest in ETFs you will see the vast choice on the market. It is very easy to get lost. In my opinion, there are 5 important criteria to consider when choosing ETFs for your portfolio:

1. Accumulating vs. distributing: ETFs can be either accumulating or distributing. An accumulating ETF reinvests the profit made throughout the year, leading to a stronger compound interest effect. A distributing ETF pays out the profit made to its investors regularly. I recommend accumulating ETFs for long-term investments. That way, the yield is higher and it is truly a passive investment. With distributing ETFs you will get paid for your investment regularly, which can be motivating, but you also need to have a plan for that money. Are you re-investing it? Or spending it?
2. Asset class: ETFs invest in equity, commodities, real estate, metals and many more. Make sure to pick ETFs that align with your investment strategy and personal values. For example, you can choose asset classes that consider environmental factors or focus on specific regions.
3. Expense ratio: One of the most important indicators is the TER (total expense ratio). The higher the TER, the lower your return on investment. Make sure to pick ETFs with a TER a maximum of 0.40% preferably max. 0.20%. Watch out: The TER doesn’t include transaction costs.
4. Trading volume: When researching ETFs online, you will stumble across the trading volume quite quickly. In my experience, it is advisable to pick an ETF with a fund size of 500 million.

A lot of beginner investors get stuck in the stage of selecting the right ETF. Don’t become a victim of analysis – paralysis! It is better to start investing in one of the major ETFs, than to get stuck overthinking and not investing at all.

Getting Started with ETFs in Switzerland

Understanding the concept of ETFs, creating your investment goals and strategy as well as selecting the right ETFs for your portfolio is the most strenuous part of your investing journey. But I have good news: Buying your first ETF is really easy! All you need is a brokerage account. If you don’t have one yet, make sure to check out my article on the best brokers. FYI: A broker in this context isn’t a human but a trading platform.

Once your brokerage account is opened, you can search for your preselected ETF (preferably with its ISIN number (a specific identification number), select the amount of money you would like to invest and then schedule the buy. Boom! You are an ETF investor. Now comes the tricky part - the most horrible bit of it all - you lean back and do nothing. No buying and selling, yes even if markets crash and a recession looms. Hold on to your ETFs and you will reap the benefits in 10 years’ time.

The one thing you need to remember about ETFs

ETFs are a great tool for investing beginners because they offer low fees, diversification and thus, lower risk. However, as with most investment tools, ETFs work best as part of a long-term investment strategy. Don’t try and use ETFs as a quick way to generate cash. Instead, do your research, design an investment strategy that helps you fulfill your long-term goals and then start investing. You will see, once you’ve taken the first steps, it gets easier every day.

Conclusion

After reading this article you should have understood that:

• ETFs are a great option for investing beginners, because they are low-cost, diversified and low-maintenance.
• Don’t get stuck in analysis-paralysis; do your research, but then pick a diversified, international ETF and get going!
• You don’t need to monitor your ETF portfolio once set up - lean back and let it grow your money automatically.

So I’ll leave you with this: Stick to low cost highly diversified passively investing all world replicating ETFs! :-)