ETF 101

Welcome back RIPvestors, time has come to get back to my investment series.

We’re going to cover the very large ETFs world in this post, the preferred mustachians instrument to join the stocks party!

Disclaimer: I’m not an expert on this subject. I’m here to share what I know with you, my novice reader, since I think it’s more than enough to get started with ETFs. I’m here to learn more on ETFs from you, my dear expert reader, so that I can improve my knowledge and act better.

Another Disclaimer: I’ll run a simulation and finally pick an ETF at the end of this post. I’m not affiliate to the financial institution emitting the ETF. I actually own ~100k USD in shares of this ETF, so it’s a product I recommend because I’ve direct experience with it. I’m not here to sell you something!

Intro

Hey RIP, what’s an ETF?

Hello friend, long time no see!

We’ve seen in a previous post what generic investment funds are and the difference between actively and passively managed and how we should aim to invest into passively managed ones.

We’re going to explore here the Fund Structure, i.e. how the fund capitalization is collected, how profits are distributed and how shares of the fund are traded. We’re going to explore 2 different fund structures: ETF and Mutual Funds.

A possible structure is the following: you want to join the fund, decide which amount you want to invest on it, deposit the amount to your fund account and then you own a fraction of it. The total fund capitalization increases when new investors join. This extra money is used by the fund manager (or by the algorithm) to buy new assets according to the fund strategy. If you want to disinvest, the fund manager is forced to buy back the number of shares you want to disinvest at its current market value. The total fund capitalization decreases when investors quit. It means the fund may need to sell assets to pay back the quitting investors. This is the common pattern of Mutual Funds.

Another fund structure that’s getting every year more popular is the Exchange Traded Funds. ETFs capitalization respects the closed-end model, meaning that no money flows in or out of the fund once created – with some exceptions (accumulating funds). So at creation time the fund size is defined and so is the individual share size. Shares are then traded on stock exchanges like regular stocks. Initially all the shares are held by the institution who issued the fund (the trust company).

An ETF can be liquidated, which means:

  • the trust company sells all the assets
  • each shareholder redeems their shares
  • the fund then disappears.

Let’s make an example: I want to create an ETF with 100,000 CHF of capitalization and shares of 10 CHF, an unrealistically small fund. My fund will than have 10,000 shares initially worth 10 CHF. No matter how many investors will come and go, the fund will always have 10,000 shares.

My fund invests on stocks of italian companies that produces Mozzarella. With a capitalization of 100K we buy 1K shares of MammaBuona, 30 CHF each, and 1K shares of PizzaBella, 70 CHF each.

The day after buying the stocks, MammaBuona performed great and their share is now worth 40 while PizzaBella performed poorly and its share is worth 50. Total value of the fund portfolio is not 90K and so each share is now worth 9.

Wait, RIP, what does it mean that ‘a share is worth 9’? Aren’t they traded like regular stocks? So they are not strictly bound to their basket value… they may go crazy due to other factors, like normal supply/demand. is it correct?

Good point. Here things become a little bit obscure to me. You’re technically right, things traded on a stock exchange can go crazy. Let’s say your fund management skills demonstrated you beat the market everytime, then investors may be willing to pay more than the market value of the assets in your basket, since you’ll surely beat the market again. I lack knowledge here. Wikipedia explain that: “The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares“. So let’s set this problem aside for a while. Well, let’s say for ever, I won’t come back on this.

“Ok, cool, but why do you advice ETFs and not Mutual Funds?”

That’s just personal taste. In US they love MFs slightly more. They have Vanguard, which is the best mutual fund company ever. Accessing Vanguard funds from Europe is more complicated and has financial implications (US Estate Tax, US dividend withholding…)

I personally prefer ETFs over MFs for the following reason: MFs bind you to a specific financial institution, while ETFs don’t. They may change their trading fees, they may go bankrupt, they may do aggressive marketing and force you to open other financial instruments with them (like bank accounts, credit cards…). Every bank has their “awesome funds you should buy” and a cool financial advisor that “works in your best interests“.

ETFs are kind of open source. Once they lift off they require less management (no external cash flow to handle) so it’s easier to make them passively managed, getting in/out is instant and cheap and they usually have lower Total Expense Ratio (TER). You don’t need to join any bank, you just need a broker to access the stock exchange(s) where the ETF is traded. ETFs are rapidly becoming the de facto standard for low cost fund investing, i.e. passively managed index funds.

Some may argue trading ETFs has 2 points of failure instead of one: the broker and the trust company managing the fund. My reply is that both have few (zero?) connections with the fund managed assets. And the closed-end structure cuts off some of the malicious strategies like Ponzi / Madoff schemes.

For the sake of completeness, here‘s a good article about why invest in Mutual Funds instead of ETFs.

Ok, cool, please RIP tell me more about stocks ETFs

Sure. We’ve previously discussed why you want to track Stock Indexes and why you want to differentiate among them. I’ve also disclosed my Asset Allocation so you know which indexes I want to track.

ETFs are tools to make your strategy happen, they are not a substitute for your strategy.

…Or are they?

Ok, let’s digress a little bit on the cost/control spectrum, i.e. how to implement your diversification strategy among the stock component of your portfolio. Usually delegating control (simplifying) comes at a cost. You could:

  • Buy individual stocks, and manually diversify. Total control, low maintenance costs. Well, costs may not be very low since you might end up frequently trading low volume stocks to rebalance your portfolio incurring in high trade fees.
  • Buy N funds that track stock market indexes and keep their value balanced (according to your strategy). You may hold a US S&P 500 Fund, a Europe Stoxx600, an Emerging Market, a Pacific… and rebalance yearly/by-quarterly/quarterly/monthly. Minimal costs, good control.
  • Buy a single World fund that tracks the entire world market, like the MSCI World Index or FTSE RAFI All-World 3000. A fund tracking such indexes keep self balancing to reflect world market capitalization and – in each market – to reflect company capitalization. Can be seen as a “fund of funds”. Given the slightly more complex behavior, usually world ETFs have higher costs (TER), in the order of 0.2 – 0.3 vs <0.1 of funds that track geographic (US, EU…) stock indexes. So, higher costs but less control. You may even buy more World funds to avoid keeping all your eggs into one basket, where the basket is the trust company managing the fund. You may even open more brokerage accounts to hedge against points of failure…
  • Use a Robo-advisor. Robo-advisors are (Wikipedia): “a class of financial adviser that provide financial advice or portfolio management online with minimal human intervention“. Essentially they are bots that keep your assets balanced, buying and selling shares on your behalf, according to a strategy. You throw money on your account and your robo-advisor knows how to allocate it. You want to withdraw from your account and your robo-advisor decides what to sell. This service comes at a price on top of the funds’ TERs. Here‘s a good US-centric article about robo-advisors. Popular robo-advisors are: Betterment, WealthfrontTruewealth (available in Switzerland). We’re not going deep there for now. Check out this MMM post about Betterment, this TSD post about Wealthfront and this JLCollins post about Vanguard for more info. Even higher costs, zero control.

I know people who operates at each level of this spectrum. Personally I adopt the “Buy N funds” approach. Minimal complexity and minimal costs.

Now we can finally dive into the mechanic of a single ETF tracking a single Stock Market index.

Is that all you can do with stocks? I heard about High Frequency Trading, Option Writing, Dividend Growth Investing…

Sure, there are countless opportunities, I know. It’s just that I’m a novice investor and all my limited knowledge is about long term investing on Stock Market Indexes. I don’t care about speculative high risk short term investments, I’m not a daytrader and I don’t wont to become one.

I’m both curious and suspicious about long term optimality of Dividend Growth Investing though. DGI means holding stocks of companies who have a long track record of having emitted constantly growing dividends over time. Here‘s an amazing introductory article on apathyends blog. Other excellent articles here and here. The good of DGI is that it’s a passive revenue stream without you having to touch the principal. The bad is that a company that issues growing dividends over time limits their potential long term growth. It’s not a coincidence that the strongest companies on the market today don’t issue dividends. Anyway, let’s just not waste time here to discuss this.

Wait, why just stocks? Why not go for angel investing, estates, precious metals, cryptocurrencies…

Wait wait wait, let’s step back. First you do your homework by asking yourself the following questions:

Q: What are your financial goals? Why are you investing? Short term? Long term?
(Mr RIP) A: I want to to reach FI and would like to live off of my portfolio profits forever.

Q: When will you need your money back? How much risk and volatility can you handle?
A: Ideally I’ll die at incredibly old age with my money still invested. I still need to be able to periodically withdraw something from my assets (ore use dividends/interests/profits). I can accept high volatility on a portion of my assets, given higher expected returns.

Q: What you feel comfortable investing in?
A: Nice question, thanks for asking 🙂 Well, this requires more space and time to elaborate, take a look at my IPS. Tl;dr: my AA (Asset Allocation) cover all the risk/reward spectrum, from super safe no reward (cash) to low risk low reward (bonds), average risk high reward (stocks) and potentially, in future very high risk high reward (angel investing / startups).

Q: Do you understand your investments?
A: Yes, I know the products I’m investing in, I’m in control of my portfolio. I made my investment choices and I’m ready to adapt them given new evidences. I know the risks. What I don’t know yet is my reaction if (when) things will go south. Will I be able to not panic? Life will tell.

Ok, ok, I got it. But I also heard of Small Cap, Large Cap, Tech, Finance, Banking and a lot of other sectors that have indexes. How am I suppose to pick my indexes? Just by geographic ares?

That’s a very personal question. Each one has their own taste and want to place their bets. My personal opinion is that sector-specific investments are inferior differentiation techniques – but I invest in a US Tech ETF, home biases die hard – while market capitalization categories are good tools to differentiate in risks/reward. Historically small caps have better returns but higher volatility. I differentiate among Large-Mid-Small Europe and Large-Small US.

Ok, let’s get back on track. You know your goals, you control your Asset Allocation and time’s finally come to pick the right ETFs to implement (part of) your strategy.

(continue on next page)

8 comments

  1. I’m very happy that investing series are back 🙂 As always, I’ve learned few new things and I thank you for sharing it with us. Really looking forward to IB 101 😉

  2. Hi Mr. RIP,

    Here one guy also trying to reach the FI, baby steps at the moment :). It’s really a pleasure to read your blog :). I also live in Switzerland and there are not so many blogs out there speaking about financial swiss topics (or at least not in English :D), like taxes.

    What’s your point of view on DGI investing from Switzerland?

    As I am building my portfolio based on that philosophy. Since I moved to Switzerland, I think it has less advantages compared to ETFs, due to the fact that in Switzerland there is no taxation on capital gains, while for dividends you pay taxes.

    When I lived in an UE country with tax on capital gains, I didn’t see the taxes on dividends as a huge disadvantage for the strategy, as anyway I would be taxed when I wanted some cash back, for supporting my living when I would be no longer working, not the case in Switzerland.

    I tend to think that, for a fiscal resident in Switzerland, dividend growth stocks are good for recession times, when at least you can, more or less, rely on your continuous stream of money. But, while in a country with taxation on capital gains by selling your stocks I would allocate most of my portfolio on DGI strategy, maybe in Switzerland I would keep an small amount, seen as a “recession proof” part of the portfolio.

    Thanks!, and really happy about your investment series!

    1. :o, I hadn’t read pages 3 and 4 when posting the comment 😀

      This clarifies a lot and destroys my ideal view of non-tax on ETFs in Switzerland 🙂

  3. Great article! I’m looking forward to the next one about IB. I wanna know if IB is good for people with little income for investing?

    1. If you go directly with IB they charge (10$ minus paid fees) per month. And their fees are very low. If you hold more then 100k in the account, there are no minimum fees. I opened account with IB trough “proxy”, which means I have lower minimum fees, but each trade is associated with higher costs. Works well for buy and hold 🙂 but not suitable for daily traiders.

      Mr. Rip: everthing ok? I’ve notice it is almost the middle of the month and no mothly update so far. Hopefully, you’re just superbusy with the wedding ceremony 🙂

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