ETF 101

Welcome back RIPvestors, time has come to get back to my investing 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!

Other posts in the Investing series:

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.

We’re finally ready for…

ETF 101

JustETF

I’ll walk you into the ETF world by simulating the decision making process to pick an ETF based on an index I want to track, which is S&P500. I’ll take screenshots from JustETF, my preferred online ETF browse tool.

I recommend you to take a look at their how-to page for an overview of geographic markets, indexes, capitalization categories and sectors.

As soon as you get familiar with the tool you can go and browse ETFs with the ETF Screener

ETF Features you should care about

Tracked index

The stock index you want to track. For our simulation S&P500.

My search returned 15 results, great. Note: your search may return different results. JustETF asks you to define your fiscal country and shows you only ETFs available for you.

So far, so good.

Fund Size

Fund size tells you the total value of the assets owned by the fund. While a large size is not optimal for Mutual Funds, it is very welcome for ETFs for the following reasons:

  1. Lower ask/bid spread: small volume means few people trading fund shares. You want to sell today? Maybe you need to wait or accept a sell price significantly lower than the market. Want to buy? Higher than the market. That is called spread.
  2. Lower costs: costs for handling more assets don’t scale linearly.
  3. better replication: we’ll discuss this later.
  4. Less risks: it’s rare a large and solid fund goes bankrupt or disappear without consequences.

So, let’s set our filter to catch Large funds:

Eight ETFs are still available.

Total Expense Ratio (TER)

We’ve previously discussed the importance of fees and how they exponentially compound over the years. TER summarizes yearly operating costs for the ETF, expressed in percentage of fund size. Usually in the range of 0-1%. Beware of funds with TER greater than 1% and in general, the smaller the better.

TER is an important factor to minimize but don’t micro-optimize for it. A difference of 10 basis points between two TERs might be swiped away by other factors like tax efficiency.

These are our 8 surviving funds sorted by increasing TER:

Use Of Profit

What does the fund do with assets’ profits (dividends for stocks)? There are two strategies here: Accumulating and Distributing.

A Distributing fund distributes profits among the shareholders every time the underlying assets distribute profits (dividends, in case of stocks).

An Accumulating fund reinvests profits according to its current strategy.

Which one is better? It usually doesn’t matter much. Unless there’s a big difference in how financial profits are taxed in all the countries involved (your country of residence, the country where the fund is domiciled, the country where the underlying assets are traded) it’s just a matter of personal taste.

Distributing funds focus on income, accumulating funds favor wealth appreciation. Tax and fees excluded it’s essentially the same. You can take dividends of a distributing fund tracking an index XYZ and use those dividends to buy new shares of the same fund and achieve the same performance of an accumulating fund over the same index XYZ.

Case of study: Switzerland

In Switzerland profits are taxed as income, while capital gain is not taxed. It means assets appreciations are not taxed, while the profits they generate are.

If you buy a stone for 100 CHF and sell it for 1000 CHF you take the difference – unless you’re a professional stone trader, in that case it’s profit and taxed as such – if you rent the stone for 10 CHF per month, the rent is taxed as income.

I got it! I got it!! On accumulating ETFs you don’t pay taxes! It’s all capital gain and no profits!

I’m sorry my friend, as you may expect the tax authority is not dumb. In general, tax authorities are smart enough you can’t play against them. You risk something horrible trying to outsmart them, like having the entire capital gain taxed as profit!

The ICTax (Income and Capital Tax) department of the FTA (Federal Tax Administration) produces every year a list of all the financial products recognized by them. If your accumulating fund is on that list, then they either know when the assets owned by the fund distribute their profits or they just make up a fictional “profits distribution date” and a precise enough “profits amount“. If you own the fund on that date, you earned profits and they will be taxed as such on next year tax declaration.

What if my fund is not on that list?

In that case all the capital gain is considered profit and you pay taxes on it. Avoid it. Always check that your fund is on that list!

For example, here’s my STOXX600 Accumulating ETF:

You can see the ISIN (International Securities Identification Number) and some of the fund details, like the fact it’s an Accumulating fund.

They have no data shown for 2017 dividends (we’re still in May at the time writing this article), they have no data for 2016 (that scares me, original taxes deadline was end of March) but they have data for 2015:

Here you can see:

  • The fund share value on December 31st 2015 – 76.70 CHF (lol, it dropped to ~61 EUR when I started investing in February 2016) – that you should use for your wealth tax (oops forgot to mention we have a Wealth Tax in Switzerland that range from 0% to 0.6% of your net worth each year)
  • The fictional profit distribution date – November 30th.
  • The value of the profits – 1.827 CHF per share (dividend yield 2.38%)
  • A simulation for 1000 shares – assets value 76.7k, profits 1.8k. Assuming marginal tax bracket of 30% the expected tax bill is 550 CHF. [Personal note: Ouch, on ~250k CHF I had invested on December 31st 2016 I may expect 5k profits (2% yield) and ~1.5k taxes for 2016 (and north of 2k on 2017) maybe I should account for that in my NW spreadsheet :(]

I got it! I got it!! I should sell the fund the day before the fictional profits distribution date and buy the fund back the day after! Since the fund is accumulating I don’t expect any loss, except 2 days of regular market fluctuations

Good luck with that! There’s a caveat: the FTA could classify you as professional trader and – listen to me carefully  – you don’t want that! If you’re a professional trader everything (including capital gain) is taxed as income.

So if your accumulating fund appreciates 10% this year while the underlying assets distribute 2% dividends (expected S&P500 dividend yield for 2017), you pay income taxes on the whole 10% if you’re a professional trader while just on 2% if you are not.

The actual guideline to avoid being considered a professional trader is: any asset you buy, hold it for at least 6 months. That’s a guideline, not a strict rule. If you play fancy you may be classified as professional trader nevertheless and if you sell assets before 6 months holding period once in a while you may still be classified “a regular person who’s managing their wealth“.

Ok… and what if I play as a professional trader or buy an accumulating fund not in the list (that issue dividends anyway) but at the end of the year the fund or my whole portfolio loses money?

That’s a tricky situation and I’ve never experienced that. In theory you don’t pay income taxes you would have paid otherwise. Not that it’s a situation that I hope, having my fund depreciating for a fiscal year… Anyway, I wouldn’t play it hard. I suspect being a professional trader is kind of viral, so you’ll pay the consequences on bull market years.

For the sake of completeness, I must mention that some Swiss companies issue special dividends named KEP (Capital reimbursement) that is not considered income. So you may find some Swiss ETF where dividends (or big portions of them) are not taxed.

Domicile

Assets have a domicile, they’re fiscally registered somewhere. If you buy a share of Coca Cola, it’s an American company, domiciled in US and traded on NYSE – New York Stock Exchange (Wall Street).

Funds have a domicile too and it’s totally uncorrelated with the assets owned. You may launch a fund domiciled in Italy that holds German stocks and that is traded in London Stock Exchange (LSE)

Why is that important? Taxes, obviously!

Case of study: Switzerland

Disclaimer: I’m not suggesting anything illegal! It’s perfectly legal to hold assets domiciled abroad and to benefit of some advantages (not many though).

We’ve already discussed profit vs wealth vs capital gain taxes. There are other tax implications you want to consider: withholding taxes. Funds domiciled in Europe and US generally withhold part of the profits the fund makes as anticipation of the actual taxes you should pay. It’s not the fund that withhold the tax, it’s the national tax authority of the country where the fund is domiciled.

In Switzerland you may deduct from your tax bill the amount foreigner tax authorities withhold from your funds. So it may seem a tax neutral process: instead of paying 100 in Switzerland you pay X in the nation where your fund is domiciled, and the remaining 100 – X in Switzerland. It’s cool.

Except it isn’t a pain-free process. You should get fiscal documents for tax withholding from the foreigner tax authorities and file them at tax declaration time.

At beginning of 2016, when I performed my deepest research in this field, Ireland and Luxembourg were popular countries for funds domicile since they don’t withhold anything for investors resident in Switzerland. I don’t know if anything changed in the meantime, I’m not keeping myself up to date on this. According to shared knowledge among invest-savvy friends and colleagues it’s still true.

So, investing in funds domiciled in Ireland and Luxembourg makes your tax declaration easier – again, that’s perfectly legal, there are no tax actually saved just a pain-free tax declaration process.

Cool, so let’s filter our ETFs by domicile now 🙂

…But there’s one exception!

US always withholds 15% (or 30% for investors resident in US) of profits at assets level.

Ok, what’s the problem? I don’t invest in US!

You sure? Don’t you want to invest in S&P500? Or a World ETF?

Yeah, but I’m going to pick a fund domiciled in Ireland, I’m smart!

The withholding is at assets level! It means as soon as companies issue dividends, US government takes 15% of it and uses it to produce more bombs. If your fund is accumulating, your share value reflects that immediately. If it’s distributing, the fund receives a dividend which is 85% of the original dividend. The problem is that it’s not you that are being taxed. Your fund is. No way you can redeem that. You end up paying double taxation on the dividends!

Oh no 🙁 we’re all doomed now, there’s nothing we can do…

Not true. You can redeem the 15% withholding tax if and only if the fund is domiciled in US via the DA-1 Form (more info here).

Hooray we saved the world!

Well, there are other implications like US Estate Tax, i.e. if you die while holding a US domiciled fund your heirs will be taxed (potentially a lot)…

Nooo, the world is doomed again… So? What to do?

Personal taste, as always. Quantity matters.

Let’s do a case study (myself) within this country level case study (Switzerland)

Nested Case Study: myself

As December 31st 2016 I owned US based ETFs for ~140k USD (94k S&P500, 48k Tech US). They are all domiciled in Ireland. Let’s see how much I am leaving on the table by not switching to US domiciled funds (assuming funds with same costs and performances).

Assuming 2% Yield on S&P500 and 1% Yield on Tech (a lot of big tech companies don’t distribute dividends), profits are expected to be ~2360 USD (1880 from S&P500 and 480 from Tech).

My unredeemable withhold tax is ~350 USD.

I’m leaving 350 USD on the table.

What do I get for 350 USD each year:

  • Simpler tax process
  • No estate tax (though it may be close to zero for such “small” amounts)

Is it worth changing strategy?

I don’t know. I’m lazy. Buying/selling at 0.08% trade fee each trade costs ~240 USD one-off. I’ll think about it.

Anyway, back on justETF. Let’s filter ETFs domiciled in Ireland or Luxembourg!

All 8 funds are still available – all of them are domiciled in Ireland or in Luxembourg – cool!

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 Interactive Brokers 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!

32 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 🙂

  4. Dear Mr RIP,

    Thanks for a fantastic blog and sharing your journey towards your goals.
    It’s been couple of months since I decided to start investing and information here is very related to my future plans when it comes to money and FI (I’m based in Switzerland too). I’ve studied a lot, defined my goals and would like to start investing using the recommended IB broker.
    As you mentioned that you use IB for your trades, may I ask were did you learn to use it? The UI interface is rather cryptic, especially for a beginner like myself, so any advice or tips would be much appreciated.

    Kind Regards
    Elvita

    1. Hi Elvita, thank you for your kind words 🙂
      I’m receiving so many requests for a IB 101 post that I’m putting it very high on my list.
      I’m currently working on a very long post that I hope to publish this weekend, then I have a couple of other interest posts I guess I’ll move to later to make room to a IB 101 post.
      I hope I can have it out during Easter 🙂

  5. Thank you for all the effort Mr.Rip, this is much appreciated.
    Looking forward to your new article!

    Kind Regards
    Elvita

  6. (Comment from user “Francesca” which apparently is blocked by WP-SpamShield):

    Hello RIP, you write:

    ‘If your accumulating fund is on that list, then they either know when the assets owned by the fund distribute their profits or they just make up a fictional “profits distribution date” and a precise enough “profits amount“. If you own the fund on that date, you earned profits and they will be taxed as such on next year tax declaration.’

    But if it is an accumulating fund you didn’t earn profits… I don’t get it, could you please explain?


    My response:
    Accumulating funds don’t generates profits to you, but invest in assets that generate profits. If that would not be taxed everybody would do the same, like creating a fund that reinvest profits and call it asset appreciation 🙂

    1. Ok, so at the end no difference between the two version (Acc and Dis) of the same ETF (some ETFs issue both forms) as regards Swiss income tax, right?

      1. There are differences.
        The Acc ETF can either be recognized by Swiss Tax Authority or not. If it’s not (you can’t find it in ictax) you better not buy this fund. All its capital gain can be taxed as income.
        If it’s on ictax, they will make up a fake dividend date and fake dividend amount that should be comparable to a distributing ETF.
        The problem here is that when the dividends are issued, some tax authority will take a withholding tax. In US this is 15% if you’re not a US resident.
        If the fund is US domiciled, you can claim back this 15% and then pay Swiss taxes on the dividends. If the fund is not US domiciled you can’t claim it back and you pay both Swiss income taxes and US withholding tax.

  7. Hi RIP,
    within your actual portfolio I found Source STOXX Europe 600 UCITS ETF A and ComStage MSCI Emerging Markets TRN UCITS ETF (both Synthetic replication).

    Why did you choose them over, let’s say, Lyxor Core Stoxx Europe 600 (DR) UCITS ETF (Physical replication, bigger AUM, less TER) and UBS ETF (LU) MSCI Emerging Markets UCITS ETF (USD) A-dis (Physical replication, bigger AUM; in this case it is because TER 0.45 vs 0.25 yours)?

    BTW, I’m learning a lot reading this post, Thank you!

    1. spoiler alert 😀
      And I think you got the Stoxx600 that I’m going to buy (MEUD). On the EM side I’ll pick EIMI by iShares, not the UBS that you suggest

  8. Hi RIP, sorry to bother you again but I’m trying to get deep down the taxation issue and I’m analyzing your post peace by peace trying to understand. Here I imagined 5 different scenarios with relative taxations outcomes or questions:

    case 1: US domiciled ETF with 100% US assets (es. VDC)
    Income taxes: via DA-1 you redeem the 15% USA withholding taxes and pay ‘only’ the swiss profit tax (which % depends upon your total income).
    Estate US taxes: when you die, if the market value of the ETF is more than 60’000$, the US ESTATE tax your heirs will have to pay is the 40% of what is exceeding the tax free limit; the tax free limit is so calculated:
    5’340’000$ x the fraction of in situs US assets of your total belongings (https://www.nzz.ch/finanzen/bitte-keine-us-aktien-vom-erbonkel-1.18379127) (https://www.amcham.ch/publications/downloads/2011/flaws_in_the_current_US_Swiss_estate_tax_treaty_and_the_need_for_a_modern_treaty.pdf)

    (beware IB users: also ‘Cash accounts with US brokerage firms’ are in situs US assets…!!!)

    case 2: US domiciled ETF with 50% US assets and 50% non-US assets (Es. VT)
    for the 50% US assets, as above;
    for the 50% non-US assets:
    Income taxes: US is not withholding anything (you wrote: ‘The withholding is at assets level! It means as soon as companies [you mean ‘US companies’?] issue dividends, US government takes 15% of it’), correct? What about the withholding taxies of all the other countries?
    Estate US taxes: again the non-US companies within the ETF are not US in situs companies so no US estate taxes?

    case 3: Ireland or Luxembourg domiciled ETF with 100% US assets (es. VDNR)
    Income taxes: USA withhold the 15% and you can not redeem it because is not US domiciled. And you pay the Swiss income taxes according to your personal %.
    Estate US taxes: none because is not US domiciled.

    case 4: Ireland or Luxembourg domiciled ETF with xx% US assets and yy% non-US assets (es. SWDA)
    for the xx% US assets: as above, case 3
    for the yy% non-US assets:
    Income taxes: only the swiss ones because the ETF is Ireland or Luxembourg domiciled? So all the other non-US countries besides L and I don’t withhold anything at asset level?

    case 5: non US, nor Ireland or Luxembourg domiciled ETF with xx% US assets and yy% non-US assets (es. ISPA, Germany domiciled)
    for the xx% US assets:
    Income taxes: USA withhold the 15% and you can not redeem it because is not US domiciled. And you pay the Swiss income taxes according to your personal %.
    Estate US taxes: none because is not US domiciled.
    for the yy% non-US assets:
    Income taxes?

    Maybe I am drowning in a glass of water here but the more I read (all over the net, there is so much confusion about it) the less I understand…

    Maybe you, with one of the most explanatory blog I’ve read so far, can help me/us clarify this mess?

    Thank you

    1. Hi Francesca, I can start by telling that that’s a mess for me too and you’re ahead of me of comprehension of US Estate Tax. Thanks for sharing the links! 🙂

      Then, let’s try to answer your points. Beware that I’m not a specialist and I don’t have much direct experience on this subject.

      1) Everything is correct, except as I said you know more than me details about US estate tax.

      2) Say a “World ETF domiciled in US”. I don’t own one (mine is domiciled in IE/LU) so I don’t have direct experience but from colleagues and friends yes, you can still file a DA-1 and get back 15% dividend withholding from US tax authority but only for the US companies (IRS, the US tax authority, has only superpowers over US domiciled companies). What about other withholding? Well, I don’t know. Maybe other tax authorities have similar double tax treaties with Switzerland and similar procedures to get withholding taxes back. Maybe some countries have zero withholding taxes (remember that withholding tax is there to prevent you to fully evade a tax, is not the final tax). Anyway, since the rest of the world has roughly the same market cap of US and there are 250 countries around it’s probably not worth the effort to go hunting for your withheld pennies.
      Whatever is left after all the withholding taxes is considered income in Switzerland, and you pay income taxes on that.

      3) “IE/LU S&P500 fund”. Correct. You pay double taxes. Something like this:
      a) the companies distributed 100
      b) the fund collects 85 and distribute it to you
      c) you pay income taxes on 85 based on your marginal rate
      That’s a simplification, the actual profits distributed for tax purposes can be looked up on ICTAX

      4) I guess this is a superposition of 2 and 3.

      5) AFAIK, non IE/LU (and non US) domiciled investments pay more taxes (they pay more taxes, so the fund can’t sustain low TERs) and European governments usually withhold other local taxes if you’re foreigners. You can always redeem these withholding taxes but it’s another painful process. IE/LU don’t withhold anything.
      So, assume you have a “DE or IT domiciled S&P500 fund”
      a) companies distribute 100
      b) the fund collects 85. Maybe other shitty taxes by Italian/German governments so the fund collects 80
      c) the funds distributes 80, but Italy keeps 26% as a “evasion prevention method”, so you get ~60.
      d) you may find a way to get back the 20 you already paid in Italy but… good luck!
      e) you will never get the 15 US withheld.

      That’s what I understood, but of course I may be wrong.
      And I’d be glad if you help me understanding better the whole thing 🙂

  9. Dear Mr. RIP,
    Thanks for your blog, very informative! I started reading you very recently and I was quickly convinced I’m doing all wrong (or nothing) with investing. I consider myself pretty ignorant on the topic and I’m looking for guidance to start a “new life”. Please forgive my very basic (sometimes probably stupid) questions in advance.

    I’ve been a Swiss resident/worker with family since a few years, but I’m a EU citizen. My savings are at UBS (yes, I know…) and a small part of them is invested in a managed portfolio (I know!), and I’m unhappy. I also have a 2nd and 3rd pillar, a few stocks of the company I work for, a mortgage on our apartment.
    I’m looking at long-term investments, maybe for slightly earli(er) retirement. I want to build a simple portfolio I can almost forget about, besides regular integrations with additional monthly savings.
    The little I read around so far (there is a lot!) made me decide that certainly I need to move away from UBS for investing, and probably open an account with IB. I guess a reasonable option is to focus on ETFs, isn’t it?

    Now, questions:
    1) Is it a good idea to move quickly and invest with IB (a lot is already liquid) all at once, considering the current market conditions? Or shall I transfer a piece at a time, over a certain period?
    2) In this situation, shall I choose a “fixed” or “tiered” commission plan with IB?
    3) Considering today’s market trends, which ETFs would you consider/pick if you were in my situation and starting today? In which proportions in the portfolio?
    4) Let’s assume I would invest 250k. For my understanding, would the (3?) ETFs I pick be different from somebody else’s investing higher amounts in the same conditions?
    5) IS it better to pick ETFs domiciliated in US or IE or mix, when there is a choice? I read previous posts, but it’s a bit unclear to me still.
    6) Since the US stock market has already grown a lot recently, is it a good reason to privilege more other geographical areas when investing today?
    7) In the future, how often shall I add additional savings to the investments? From a cost perspective, is it worth to buy quotes monthly?

    Thank you very much!

    1. Hi Happydad, welcome to retire in progress 🙂
      I’m happy I contributed to your “financial epiphany”, now it’s time to act 😉

      1) I’d recommend you to move the funds all at once but then decide whether to invest all at once (a.k.a. lump sum, recommended by RIP) or a constant amount each period over a limited horizon (1 or 2 years, a.k.a. dollar cost averaging, recommended by many – not RIP). The advantage of lump sum investing is that you spend more time in the market, i.e. greater expected returns, while DCA minimizes volatility (but lower expected returns). Risks vs Reward. In no case we’re trying to time the market.

      2) Always tiered if you plan to buy European domiciled ETFs (https://www.interactivebrokers.com/en/index.php?f=1269). If you go for US domiciled securities, it strongly depends on volumes, but it’s negligible and unless you trade a lot and high volumes (6-7 digits trades) stick with tiered. So IO’d recommend tiered, even though it’s not a huge difference. In my experience I used to have fixed commissions and I remember paying roughly 0.1% trade fee on my trades. With tiered I’m around 0.08%.

      3) I’ve written a detailed post in April, take a look at it. Mind that it’s my personal strategy and it varies from time to time. Use it as a reference, but take your time to adapt it to your goals, bets and personal taste. Still, don’t adapt your strategy to “today’s market trends”, you and I have no idea what it means. Do not try to be smart.

      4) My current strategy scales linearly with amount invested. If I had an extra 10 Million CHF I’d use the same scheme. Well, maybe I’ll diversify even more and try other bets like p2p lending, some rental properties and maybe startups but only if and when my nest egg will reach at least 150% of my FU number 🙂

      5) It depends. There are pros and cons. When I started investing the US Estate tax scared most of my friends and colleagues so it was common knowledge to stick with Ireland or Luxembourg. Now I have a lot of friends who owns US domiciled ETFs. M<ind that the hassles to get dividend withholding back is not negligible. It’s probably worth above a certain threshold to go with US domiciled funds. Run your numbers. Mind that different investments have different taxable profits. 250k invested in S&P500 (Yield 1.8%) generates less profits than 250k invested in High Yield Dividend stocks (3.5-4%) but more than Small Cap stocks (1%), but even less than Preferred Shares (6%), but even more than Nasdaq stocks (<1%). Find your threshold. Mind that higher yield doesn’t mean better investments. GameStop (GME) is paying 10% dividends (almost considered in liquidation) but its stock price is in free fall since 5 years. in general, lower dividend means growth, while higher dividend means value. Growth stocks historically outperformed value stocks (but higher volatility…)

      6) bullshit. Don’t time the market. US stocks are the best performing in my portfolio in 2018. Add to that the USD is also performing better than CHF and EUR. Don’t try to be smart.

      7) invest regularly each month. With tiered pricing structure you don’t pay minimum fees so even 1k is worth investing right away.

      1. Thanks MrRIP, very useful!
        I’m reading more and more and I start having an embrionic idea of what I could do. However, there’s so much I would still need to learn on the topic!
        I’ll ask you a few more questions, if you don’t mind.
        1) My 2nd pillar is pretty heavy on my total wealth; my 3rd pillar is 50% invested in a Postfinance 45 Pension Fund. I’ll certainly keep 6-month of cash. Shall I consider them a sufficient “bond” allocation, or shall I still allocate a percentage of the portfolio created at IB to bonds?
        2) I’ve collected more information and I have the impression that for Swiss residents it’s ok to have US domicilied funds and still avoid US extate tax in case. Therefore, I’m considering the same “lazy” portfolios I found discussed in many places. At the moment a “3 funds” type or a “Ferri’s core four” type portfolios make sense to me. I’m a very beginner, so I wouldn’t really touch anything without advice. In Switzerland, would it make sense to adopt the strategy recommended in the US, or do I need to have to protect myslef with a home bias in CHF? In US I saw they recommend for the 3 funds:
        – VTI – Vanguard Total Stock Market ETF (55-60% of the stock part?);
        – VXUS – Vanguard Total International Stock ETF (40-45% of the stock part?) (or alternatively VEU?);
        – BND- Vanguard Total Bond Market ETF (in case I need bonds on top of my 2nd-3rd pillars).
        3) I have a brokerage account with Fidelity because of the company I work for, with very little on it. It seems Fidelity offer free trades on “equivalent” funds and comparable TERs, for the following:
        AGG – iShares Core US Aggregate Bond ETF;
        IXUS – iShares Core MSCI Total International Stock ETF;
        ITOT – iShares Core S&P Total US Stock Market ETF.
        Is it by any mean worth considering going with Fidelity if the portfolio is the above instead of IB, or is their currency exchange rate (and maybe other fees) too high?

        Thanks!

        1. 1) If you want to be able to rebalance between stocks and bonds you should have bonds that you can sell. Apart from that, you should define your acceptable percent of bonds in your portfolio and see how much you have in pillar 2&3 and see if it’s close to your desired percentage. I’d recommend somewhere between 20% and 40%
          2) if you feel confident in US domiciled funds, go for them 🙂 About the asset allocation it seems you’ve done your homework and know the lazy portfolios. I’d be a little bit more home biased (unless you’re ok with depending so much on a foreign economy) but in general the 3 funds portfolio you are thinking about is good enough.
          3) Fidelity is one of the best provider in US, so I guess it’s reliable and low cost enough. I’m not aware of what kind of limitations it has though.

          It seems you’re good to go and already know more than enough.
          You’re focusing on minor details right now – which is ok – but remember that your strategy will be tested for real when you’ll face a 10-20-30-50% market drop. Instead of focusing on which ETF has lower TER, focus on testing how your brain will react when you’ll lose 100k in a week.

  10. Thanks MrRIP!
    One more source of confusion for me, maybe I missed it from your previous posts:
    if I want to buy an Ireland-domiciled ETF which is listed in different stock exchange markets and in different currencies (EUR, GBP, USD, CHF), is it better for a Swiss investor to buy it at SIX in CHF (to avoid currency exchange fees) or not (higher costs), assuming you are using IB? For example, Vanguard FTSE All-World UCITS.
    Thanks for your help.

    1. It doesn’t really matter much.
      If we wan to delve in micro optimization, the things to consider are:
      – your currency of use: maybe CHF, but I also earn USD from stocks sale
      – trading amount on currency X for your ETF: my S&P500 ETF is traded way more on LSE in USD than in CHF on SIX, so I can find better spread
      – trade fees on stock exchanges: SIX is not a cheap stock exchange.

      But as I said, it’s a minor issue.

  11. You discussed withholding in EU (various percentages at fund level, 0% in IE/LU) and US (15% at asset level, redeemable with DA1). How about other domiciles, in emerging markets? Is it generally 0 or generally complicated? Or would you just pick IE domiciled EM ETFs?

    1. You also wrote elsewhere that you switched from CBMEM to EIMI because (among other reasons that I do understand) it has lower taxes. First is domiciled in LU, latter in IE, so both should be 0% withheld, unless the fund withholds something in a different way. One factsheet mentions tax withholding but not its value, and no mention of taxes in the other factsheet.

      1. Well, CBMEM was not a good fund fr other reasons like small capitalization and shitty replication model. The tax impact is what I dug from ictax between 2015 and 2017.
        Let’s recall that in CH we don’t have capital gain tax, but swiss tax authority will tax your accumulating ETFs based on what the underlying assets have distributed.
        Else an accumulating ETF would be a way to cheat and make profits seem like capital gain.

        CBMEM has been assigned by ICTAX “virtual dividends” of 2.97%, 2.27%, 3.60% of the end-of-year share value between 2015 and 2017. Why? I don’t know, probably the fund owned more high dividend stocks.
        EIMI “virtual dividends” have been 1.74%, 2.25% and 1.59%. Significantly less than CBMEM. Why? Maybe different stock selection.

        But wait, they’re both replicating “MSCI Emerging Markets” index! Apparently they’re replicating it differently.

    2. That’s my model (don’t know how right and/or wrong):

      Given that:
      – I know how US profits are taxed at source by the IRS (15% with a W8-BEN, 30% otherwise).
      – I know how funds domiciled in US don’t get taxed at source, but you get. You can claim that tax with a DA-1 form if you pay taxes in CH
      – I know how funds not domiciled in US gets taxed at source while collecting dividends, then forward what’s left to you and you have no way to claim that tax back. You then get taxed again by CH.
      – I invest heavily in US
      I conclude that:
      – it makes sense to invest in a US domiciled fund to save double taxation on dividends.

      Given that:
      – Other countries tax at source their profits differently (here’s a withholding tax rate by country: http://taxsummaries.pwc.com/ID/Withholding-tax-(WHT)-rates)
      – I don’t know if you could get back withholding tax from such countries.
      – I invest little in large markets (Pacific, Euro, Emerging) that are composed by many countries, with different withholding model.
      I conclude that:
      – It’s almost impossible to tax optimize on 100 countries, so I’m ok with getting double taxed, i.e. I’m ok with IE/LU domiciled funds.

  12. Ciao Mr Rip.
    I m Feancesco from Italy. I ll write you in english in case someone who do not understand italian is interested.
    What about investing for early retirement in Italy? It would be very useful if you can share with us all your useful ideas/investments for someone who is Italy based.

    Grazie!
    Francesco

    1. Hi Francesco, it’s a very interesting and complex question for which I don’t have an answer yet.
      I recommend to follow other amazing blogs on the subject, like incassaforte.com.
      I plan to dig deeper into the “Italian nuances of Early Retirement” in the near future.

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