If you want to buy a stock ETF, you should consider a few points. Not all ETFs that invest in stocks are suitable for building wealth or for retirement planning. Therefore, find out in advance which criteria are important when making your selection.

The most important thing in brief:

• An ETF is an investment fund that is traded on the stock exchange and whose investment strategy is to replicate a specific index. 
• The more stocks there are in the stock index, the better the risk diversification. This means you can easily invest in more than 3,000 stocks worldwide with an ETF.
• When choosing an ETF, you should also pay attention to low costs and high fund volume.

ETF: What is it anyway?

Exchange Traded Fund, or ETF for short, means “exchange-traded fund”. Compared to actively managed investment funds or certificates, it is simply structured and very transparent. However, a stock ETF that aims to build wealth or provide for retirement should be spread as widely as possible – ideally worldwide – using a suitable index. However, this is not the case for many stock ETFs, which is why they are not suitable for these goals. You should therefore find out about the most important selection criteria in advance.

Information on the criteria for ETFs can also be found in the respective “key investor information” or in the “fact sheets” of the funds. You can access them on the websites of your bank, the fund company or on financial information portals on the Internet. You can read more about the advantages and disadvantages of ETFs in the linked article.

ETFs: The index shown

ETFs are generally classified as investment funds, of which there are many different types. However, they have two special features. The first is that they are traded on a stock exchange. Hence their name: ETF stands for Exchange-Traded Fund. 

Compared to funds that cannot be bought on the stock exchange, exchange-traded funds have a decisive advantage: they are cheaper because you save on the so-called issue premium. 

The second special feature of ETFs is that their investment strategy is to replicate the performance of a specific index. This also has significant cost advantages for you as an investor: the annual management costs are lower than for other funds. 

However, there are many indices that are not suitable for a long-term investment strategy. Some indices contain only a few stocks and are therefore unnecessarily risky. Others are calculated according to complex and not so easily understandable criteria, which is the case with so-called sector, strategy or factor indices. These try, for example, to combine stocks with particularly high dividend payouts or particularly fast-growing companies in a sector in one index.

Such ETFs are not the first choice for wealth building because they usually only yield below-average returns. Above-average returns are purely a matter of luck. There are only two factors that are crucial for a successful investment strategy: broad risk diversification and low costs. With ETFs that replicate the following indices, you get a very broad risk diversification on the stock market:

• The MSCI All Country IMI Index has the broadest diversification with around 8,800 stocks .
• The MSCI All Country World Index with around 2700 stocks, the FTSE All World Index with around 4200 stocks and the Solactive GBS Global Markets Large Mid Cap Index with around 3500 stocks also offer a very broad diversification, albeit without the smaller companies.
• The FTSE Developed Index  contains over 2,000 stocks and
• MSCI World has around 1,400 stocks worldwide. However, emerging markets are not included here.

The aim of the above-mentioned indices is to replicate the development of the stock markets worldwide. An ETF that tracks one of these indices offers a sufficiently broad risk diversification. Alternatively, you can also put together a global portfolio yourself by combining ETs on some other indices from the major investment regions. In this case, the following indices are possible:

• Europe: Stoxx Europe 600, MSCI Europe, FTSE Developed Europe,
• North America: S&P 500, MSCI USA, MSCI North America,
• Emerging markets: MSCI Emerging Markets.

There are ETFs from various providers for all of the above indices. They all bear the name of the index, usually supplemented by the name of the publisher and an abbreviation that indicates how the income is used. ACC stands for accumulating income, DIS for distributing income.

There are also a variety of indices for ETFs that invest in bonds rather than stocks. They are generally less well-known than stock indices. Examples of indices on bonds from the eurozone are:

• Corporate bonds in euros: Bloomberg Euro Corporate Bond Index,
• Government bonds of the euro member countries: Bloomberg Euro Aggregate Treasury Index, iBoxx EUR Sovereigns Eurozone or Bloomberg Euro Government Bond 1-3yr Index.

But here too, investors should look at what an index contains. The information is available in the index provider’s fact sheets, which you can find on the Internet if you search for the index name and a PDF file. Important information is

• the remaining maturities of the bonds included,
• the creditworthiness of the issuers, with government bonds being safer than corporate bonds and
• the currency in which the bonds are quoted.

How much do ETFs cost?

To buy ETFs, you must place a securities order because ETFs are acquired via stock exchange trading. The one-off costs for this are usually zero to 1 percent of the investment amount, depending on the direct bank or broker. With actively managed funds, however, you usually have to pay an issue premium of 5 percent.

The ongoing costs are also lower for ETFs. Actively managed equity funds charge an average management fee of around 1.5 percent per year. With ETFs, investors usually have to pay more than 0.2 percent in management fees per year. In addition, the transaction costs for ETFs are much lower because the securities contained in the fund are not bought and sold as often as is the case with active investment strategies.

Equity ETFs: How are returns used?

Equity ETFs generate ongoing capital gains. These are regular dividend payments from the companies in the fund’s assets. Bond ETFs instead generate interest payments from the issuers of the bonds. Like other investment funds, ETFs differ in what they do with this income. There are basically two options:

• ausschütten, or English “distributing” or
• accumulating.

Distributing ETFs pass dividends and interest directly to investors once a quarter or once a year. The money is then posted to the portfolio’s clearing account. The ETF’s share price drops by the amount of the distribution. You can then either reinvest the payout or use it for something else.

Accumulating ETFs, on the other hand, reinvest the funds they receive in buying fund shares. The money therefore stays in the fund and investors do not have to worry about reinvesting it. However, they also do not have any ongoing income.

For tax purposes, distributing and accumulating ETFs are treated similarly. You can therefore choose the use of income that best suits your investment goal. When building wealth over the long term, accumulating is usually the most convenient option.

How high should the fund volume be for ETFs?

There is a simple rule of thumb for this criterion: only choose funds that have a fund volume of at least 500 million euros . The lower the assets managed in an ETF, the greater the risk that the fund company will close the fund at some point or that it will be merged with another fund. 

Neither is a disaster, but it can cause additional costs if you want to reinvest your funds. If an ETF merges with an ETF that has a different fund domicile, for example an ETF from Luxembourg with an ETF from Ireland, this is also a sale for tax purposes. In this case, interim profits may have to be taxed if the savings allowance has already been exhausted.

Larger providers have an advantage in this respect because their funds often manage more assets. And widely used indices are once again better than exotic ones.

What is the fund currency for ETFs?

Some ETFs are traded in US dollars (USD), others in euros. Which currencies are included in the fund assets depends only on the respective securities. Shares of American companies are always traded in US dollars, shares from Switzerland always in Swiss francs, etc.

With an ETF that is diversified worldwide, you automatically always hold a broadly diversified basket of currencies. Because most of the largest stock companies in the world are based in the USA, the US dollar dominates as a currency in the portfolio of ETFs that track the MSCI World, the MSCI All Country World or the FTSE All-World. This sometimes increases or reduces investors’ returns in euros, depending on how the exchange rate develops.

The currency of the ETF is therefore not a selection criterion. If you do not want to bear currency risks, you must either select ETFs that hedge these risks. They are usually marked with the addition “EUR hedged”. However, this is expensive, which is why consumer advice centers advise against it for long-term investment strategies. Alternatively, you can also select ETFs that only contain securities from the euro zone.

How are ETFs structured?

ETFs replicate indices in three main ways: fully, optimized or synthetically. All three methods have their merits and are no worse or riskier than the others.

1. Either they actually hold all the shares in an index directly – in the same proportion as they are represented in the index. This process is called full replication . It is usually not offered because full replication is expensive, especially for very large indices that also contain many smaller shares.
2. The funds usually only contain a section of the shares in the index, supplemented by some derivatives. This is then referred to as an “optimized” replication .
3. In synthetic replication , an ETF holds securities that have nothing to do with the index and simultaneously concludes a contract, a so-called swap agreement, with a bank. The bank undertakes to balance out the differences between the performance of the index and the basket of securities held by the fund.

For detailed explanations of how an index is mapped , read this article.

What is the tracking difference?

The tracking difference quantifies the difference between the return of the fund and the return of the index. Theoretically, it is roughly equivalent to the level of the ongoing costs. In practice, it is sometimes higher, sometimes lower. There can be various reasons for this:

• How is the tax deduction calculated for income distributions in the index and the actual taxes on the fund assets? For some indices, such as the Euro Stoxx 50, the return on ETFs is therefore regularly even higher than that of the index (but this does not mean that these ETFs are better than others).
• What does the liquidity position look like, for example after dividend payments? More liquidity when share prices rise increases the tracking difference.
• Have securities lending proceeds been credited? Some providers credit more than others, which reduces the tracking difference.
• What is the timing of index adjustments? The stocks included in the stock indices are exchanged from time to time. This can also result in a (random) difference to the index.

The tracking differences are very small for the major global stock indices mentioned above. You can see this indirectly from the fund return over the last calendar years if you compare this return with that of the index.

When making this comparison, make sure that the currency of the fund and the currency of the index match. Some providers show the returns in USD in the fact sheet if the index is calculated in US dollars. This is usually the case for all global indices. Other providers show the returns in euros in the fact sheet, including those of the indices.