ETFs have been available in the financial markets since the 1990s, but what are they exactly? An Exchange-Traded Fund, or ETF for short, is a fund that can be bought on exchanges during opening hours, just like equities, and for which you do not need to wait until the daily cut-off as is the case for mutual funds.
ETFs aren’t the only type of investment fund you can buy. Several types of investment funds exist such as mutual funds, money market funds, or hedge funds. Mutual funds can be purchased directly through the fund management company, or through a broker. A mutual fund is a pool of money coming from many investors that are managed by professional asset managers and invested in bonds, stocks, or other types of securities. Funds are often appreciated by investors for the diversification they offer, as if you buy a share, you are exposed to all the underlyings of that fund.
ETFs have been gaining popularity for the past 20 years, mainly due to their prices. But, are they truly that cheap?
A closer look at ETFs
ETFs are Exchanged-Traded Funds, they are called that way because they are traded on an exchange like stocks. Their price varies throughout the day based on the way shares are bought and sold, and most importantly based on the ETF underlyings, which are the constituents of the ETFs – that can be equities, bonds, or even commodities for instance. But what makes them special is that their primary purpose is to replicate a benchmark. This is why most ETFs are considered as passively managed instruments.
Just for information, a benchmark is an index created that groups many securities, in a way that it replicates a given market or market segment. For instance, you have benchmarks replicating the performance of the top 500 companies in the US (S&P 500) or the 20 top companies in Switzerland (the SMI). There are also much more specific benchmarks like the “Nasdaq Biotechnology Index” that tracks the US-listed companies active in the biotechnologies sectors.
There are around 2300 different ETFs that a Swiss investor would typically get access to through a Private Bank. For simplicity reasons, we will classify them for the sake of this article between non-specific ETFs and specific ETFs. Non-specific ETFs are ETFs that track a simple and widely recognized benchmark (such as the S&P 500), whereas specific ETFs are more niche ETFs, more complex (thematic, ESG, sectorial…).
Among the most popular there are:
Equity ETFs: These ETFs will allow you to invest in stocks from a specific country, like Switzerland, or to invest in a specific sector.
Bond/Fixed Income ETFs: You would here invest in bonds of specific countries or companies. Bonds are generally considered as instruments with a lower level of risk than stocks.
Commodity ETFs: Invest in commodities like gold, wheat, etc…
Thematic ETFs: Invest in sustainability, social topics, or other themes. It is one of the most popular categories of ETFs.
So, are they truly cheap?
When we say that ETFs are cheap, we are usually comparing them to mutual funds as both constitute baskets of securities. Investing in ETFs can indeed be cheaper than investing in a mutual fund. But it really depends on the kind of ETF you want to invest in.
For example, let’s say you have 100,000 CHF to invest for 10 years and that you are wondering about how management fees would impact your returns. Let’s assume an annual 6% return on all markets, and that all returns are compounded (reinvested). You have the choice between 2 ETFs: An ETF with a 10 bps (Basis Points) fee and another one with a 100 bps fee. Here’s what 100,000 CHF might get you at the end of the period:
- 162,889 CHF for the ETF charging 100 bps annually
- 177,402 CHF for the ETF charging 10 bps annually
What did we discover with this comparison?
Some ETF classes are on average cheaper than others. For instance, in the case of “simple tracking” ETFs, fixed income government bonds ETFs cost on average 0.14%, while High yield ETFs cost 0.40% (Figure 2). Equities US ETFs, are also on average cheaper than European equities ETFs (0.16% vs. 0.26% – Figure 2), then come global Equities ETFs (0.37% – Figure 2) and Emerging Markets Equities ETFs (0.39% – Figure 2).
Commodities (0.51%), multi-assets ETFs (0.52%), and cryptocurrency-based ETFs/ETPs (1.83%) appear as the most expensive in terms of management fees (c.f. graph “What it costs to replicate” – Figure 1).
Moreover, the more complex we go within an asset class, with the ETF management (for example by replicating only a sector, or by screening the market for thematic ETFs), the more expensive the ETF will be. Which makes sense, since there is a little extra which is done by the portfolio manager.
ETFs that are the cheapest are the ones that simply and purely replicate a benchmark, without any additional work. The moment when the manager actually starts screening the market looks for alpha generation, or works with a more complex product or on “impure” asset classes, is when the management fee starts going up, although it remains a passive investment. Nevertheless, in counterparty, you also gain more “control” over your investment in the sense that you can express a more precise view through a specific ETF. For instance, investing in an ETF that plays the “innovation” card is more specific than an ETF that buys all the US companies.
In this case, you might want to compare with actively-managed securities like mutual funds where there will actually be a lot of research before each investment decision. You can think of it this way: Imagine you were to buy the basic model of a car, to which you would add so many options that the price would actually become more expensive or equal to the next model of that same car, which already has all the options that you just added as a standard and a bigger engine. It would be better to pick the other car, right?
Do not get hung up in buying an ETF if you require something so specific that a mutual fund or an actively managed portfolio would do better (and cheaper sometimes).
In the end, ETFs are not all the same. Each of the several thousands of ETFs that exist right now have their own management fees. And that means that not all of them will deliver the same net of fees performance.
ETFs offer in many instances a convenient and cost-efficient way to access the markets but are not a miracle product by themselves, as fees can grow quite fast. When fees become too high, you might be better off investing with an asset manager, through mutual funds for instance, where there is active portfolio management behind. This active solution can be cheaper than the passive one that is only following a benchmark.
Always ask yourself: what am I getting for my money?
As a separate note, management fees are not all the fees charged by an ETF or a fund. A more accurate number to check when taking a look at a fund is the TER – Total Expense Ratio, which is located on the factsheet, KIID, or Prospectus of a fund, and that summarizes all the fees that will be charged to the investor by the fund.
Alpian has submitted an application for a full banking license to Switzerland’s Financial Market Supervisory Authority (FINMA). Content of this publication is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.