What are ETFs? Everything you need to know

ETF definition and characteristics 

An ETF is an exchange-traded fund that tracks an index of an industry, region or asset class and allows investors to invest in a variety of securities by purchasing a single share. ETFs can therefore offer a diversified investment opportunity, which can contribute to risk reduction compared to an investment in individual equities. Since they are traded on the exchange, they can be traded flexibly like equities. As a passive investment, which is basically limited to replicating an index, they are generally a cost-effective investment instrument. On the other hand, this means that an excess return compared to the index is not possible. 

ETFs offer a wide range of investment opportunities. You can invest in different asset classes such as equities or bonds. In addition, there are ETFs that focus on specific geographical regions such as continents or countries. Thematic ETFs focus on specific sectors or trends, such as renewable energy or healthcare innovation. No matter your investment preferences, you have the option of finding an ETF that meets your requirements.

What types of ETFs are there?

ETFs typically offer a diverse range of investment opportunities covering different asset classes, geographical regions and themes. The most well-known asset classes include equity ETFs that replicate the performance of a specific equity index, and bond ETFs that invest in fixed-income securities such as government or corporate bonds. In addition, there are ETFs that focus on specific geographical regions or countries. Thematic and sector ETFs focus on specific industries or long-term trends, such as sustainability, renewable energies, technological innovations or the healthcare sector. 

• Equity ETFs

Equity ETFs are among the most frequently traded ETFs. They aim to replicate the performance of a specific equity index such as the S&P 500 or MSCI World. These ETFs offer investors the opportunity to invest in a large number of companies by purchasing a single investment product. This reduces the risk compared to buying individual equities. There are also specialised equity ETFs that focus on specific industries, as well as those that focus on specific regions or countries.

• Bond ETFs

Bond ETFs invest in fixed-income securities such as government bonds or corporate bonds. These ETFs offer investors a way to diversify their portfolio while generating regular income through interest payments.

• Sector and thematic ETFs

Sector and thematic ETFs focus on specific industry sectors or investment themes. Sector ETFs invest in companies operating in a specific economic sector, such as energy, finance or consumer goods. Thematic ETFs, on the other hand, focus on long-term trends and innovations, such as sustainability, renewable energy or artificial intelligence. These ETFs offer investors the opportunity to invest in areas that they consider promising for the future and benefit from their growth prospects.

How does an ETF track an index?

An ETF tracks an index by replicating all or part of the securities included in the index. In the case of full replication, the ETF buys all the securities in the index in the same weightings as the index itself. With partial replication, also known as sampling, the ETF buys a representative selection of the securities that make up the index to replicate the performance of the index as closely as possible. Both methods aim to reflect the performance of the underlying index as accurately as possible, with full replication typically providing higher accuracy, while sampling can be more cost-efficient.

How do physically and synthetically replicating ETFs differ?

ETFs can replicate an index in two different ways: physically or synthetically. Physically replicating ETFs buy the actual securities that make up the Index either in full (full replication) or in part (sampling) in order to replicate the performance of the index as closely as possible.

By contrast, synthetically replicating ETFs use derivatives to achieve index performance. Instead of buying the securities directly, they enter into contracts with counterparties that guarantee the return of the index. While physically replicating ETFs offer direct replication and thus greater transparency, synthetically replicating ETFs can be more cost-efficient and enable investments in difficult-to-access markets. However, synthetically replicating ETFs carry a certain counterparty risk, for instance if the counterparty to the financial transaction fails to fulfil its contractual obligations, which can lead to losses.

How do ETFs differ from index funds?

ETFs (exchange-traded funds) and index funds are both investment instruments that replicate the performance of a specific index. The main difference lies in their liquidity and how they are traded:

• ETFs are traded on exchanges like equities and can be bought and sold flexibly during trading hours, providing high liquidity.
• Index funds, on the other hand, are traded directly through the fund company and are settled at the net asset value (NAV) only once a day.
• ETFs often offer lower costs and more flexibility, while index funds can be suitable for long-term investors who want to trade less actively.

The advantages of ETFs at a glance