ETF 101

Index Replication

A fund matching S&P500 index is supposed to own assets that emulate the actual S&P500 basket, i.e. stocks of the top 500 US companies. How many stocks for each company? Enough to replicate the relative weights of each company within the index basket, i.e. the relative market capitalization.

For example, if Poca Cola market capitalization is 100 and Apfel 1000 (I just made these numbers up), the value of Apfel stocks in the fund should be 10 times the value of the Poca Cola stocks.

Having a fund that owns stocks in the exact proportions (and keeps them balanced regularly) is very hard, not least because it would have to be very very large. Think about Berkshire Hathaway (Warren Buffett and Charlie Munger company) stocks. A single stock is quoted 243k USD (May 2017) and its weight within the S&P500 is 1.51%, which means that holding a Berkshire Hathaway stock requires 16M USD to keep the fund balanced. Let alone that there are funds smaller than 16M USD around, if your fund capitalization is 20M there’s no way they can perfectly replicate the index!

Whaaat? So they are liars!!

Well, no. They’re allowed to approximate the index, given it’s clearly stated. That’s called Index Replication Strategy.

I’m aware of two families and several strategies within the families.

First family is Physical Replication, i.e. the fund owns actual stocks. It can be Full Replication where, as you may imagine, the actual index is perfectly replicated or Sampling where the fund owns a subset of the stocks guaranteeing a low deviation from the index. Sampling is adopted when Full Replication is impossible (fund capitalization too small) or inefficient (too many trades and small quantities traded, i.e. fund still not big enough). Here a nice article about Full vs Sampling.

Second family is Synthetic Replication, where instead of actual stocks the fund owns collaterals, swaps and other derivatives… I don’t know you, but I prefer to avoid another point of failure in my chain so I try to avoid them. Here more info from investopedia.

Anyway, let’s filter for Full Replication!

Still 4 funds left! How to choose? Well, let’s look at the performance.

Tracking Error – Performance

No matter how perfect and real time rebalanced a Replication strategy is, your fund will always perform differently compared to the index it tracks. The term Tracking Error indicates how closely a portfolio follows the index to which it is benchmarked. There are mathematical formulas to calculate the TR, usually as a standard deviation of value difference between fund share and index over time… But who cares about these boring details?

What matters is: given several funds that track the same index, which one performs better?

The answer may seem obvious: the one who performed better so far.

Which is mostly how I evaluate funds after all other aspects have been took into account. Just remember that even few consecutive years of “better performance” of a sepcific fund may mean nothing if its Tracking Error is high. Good performances might have happened by luck and thanks to lucky sampling (see replication). Aim to lower standard deviation (volatility and risks) instead of getting tempted by returns above the market.

What are the performances of our finalists funds?

You can see that the first one (iShares) is accumulating and the other three are distributing. I didn’t filter by “Use of Profit” on purpose. Didn’t have any preference.

From a performance point of view the first one outperformed the other three since forever, excluding last 3 months. And it has a smaller TER. Aaand 10x Fund Size (except against Vanguard). I assume returns include reinvested dividends for the two distributing funds, it wouldn’t make sense otherwise.

So we have a winner, iShares (by Blackrock) Core S&P 500 UCITS ETF (Acc).
Here‘s the profile and here‘s the factsheet.

Super, thanks RIP! I want to buy it, how do I do? Should I call BrackLock and ask??

Uhm… first of all it’s called BlackRock. Second, you need a broker and that’s the main topic for next post (Interactive Brokers 101). But let’s explore few preliminary activities you want to do before entering a BUY offer on your broker.

From Funds to Shares

You have your ETF and you want to buy shares of it. How does it work?

Each Security has a unique identifier called ISINOur ETF ISIN is IE00B5BMR087.

Note: first 2 letters indicates country of domicile, Ireland in our case.

Note: if you want to check an ETF profile given its ISIN on justETF, just alter the url:

https://www.justetf.com/en/etf-profile.html?isin=YOUR_ISIN

Awesome, where should I enter my ETF ISIN in my broker application??

Calm. The ISIN is sometimes not enough to buy an ETF.  Why? A single ETF may be traded on different Stock Exchanges, in different currencies, with different Ticker Symbols. A Ticker is a unique identifier for a particular stock on a particular stock market. And yes, your ETF shares are stocks.

So you need a ticker. Let’s look up for our ETF ticker(s). Just click on the Listing tab of the profile page on justETF.

aaaand…

Hoooly craaaap! 8 tickers (wait, weren’t they supposed to be unique?)! 6 Stock Exchanges!! 5 currencies, including Pence Sterlings!!

Well, we picked the biggest (by market size) ETF, domiciled in Ireland, tracking a very popular stock index like S&P500. What did you expect?

Ok, so… which one is the one I want to buy?

Again, personal taste. I must admit my knowledge starts to fade a little bit while in this dark territory.

Let’s take a look at the currencies first. Your Fund owns assets that are evaluated on a certain currency. For example, S&P500 tracks US companies so the underlying assets currency is USD.

Does it matter? Well, a little bit. If you own a Car Wash in US and if the USD loses half of its value against EUR – and you measure your wealth in EUR – you’ve lost half of the money. If you own a share of a global company (say Apple) even in case the USD worth half a EUR when Apple sells iPhones in Europe they would make way more USD than they make now, and their stocks would grow (in USD).

What I’m claiming here is that Globalization acts as an hedge against currencies fluctuations.

There are Currency Edged ETFs. Beware of them though. The reduced volatility is not worth the cost in the long term.

So, in the end, you shouldn’t care about underlying assets currency for Large Cap stocks (like S&P500), while it matters a little bit for Small/Medium Cap, which might operate only in their country.

So… should I buy the one listed in USD?

Don’t rush my friend!

And btw, we only discussed the currency of the underlying assets, not the currency of the ETF shares.

Technically, the performances of your ETF are not impacted by the currency of how shares of your ETF are traded. That should just be a convenient currency for you. Every currency conversion comes at a cost, minimize them!

Beside traded currency, another factor may impact more: the Stock Exchange. Stock Exchanges have their own rules and markets. Smaller stock exchanges have less investors trading, less trading volumes, higher buy/sell spread. You may find yourself wanting to sell while none wants to buy, so you end up selling at a lower price than the market.

Anyway, for long term investors like us, these are just insignificant details. I picked one in USD, traded in London Stock Exchange. Actually JustETF is not up to date, since my InteractiveBroker app tells me that my Ticker is CSSPX.LSEETF and that’s not listed in the screenshot I showed to you.

Yes, since ETFs are becoming so popular, London Stock Exchange recently split and now we have LSE and LSEETF, just for trading ETFs!

That’s all my friends!

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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