How do you actually invest your savings in times of crisis and inflation? And what should be invested in? Exchange-traded funds, so-called ETFs, have long been praised as an alternative for ordinary consumers. TECHBOOK explains what is behind the ETF trend and shows the advantages and risks.
Even after the European Central Bank has said goodbye to the zero interest rate policy and is slowly raising interest rates, there are still no advantages for the average saver. Inflation and rising prices are slowly but surely eating away at the money that has been put aside. Investing your savings and letting them work for you is risky, but there is often no way around investing in the stock market and securities if there is a lack of interest on the current or savings account.
The multitude of opportunities to invest in the financial market overwhelms many. Often there is a lack of the necessary knowledge or the time to constantly deal with worthwhile stocks and the fluctuating prices. Active investing in the stock market, i.e. selecting securities from specific companies, is sometimes risky and requires experience. Finding the right time to buy also poses a major challenge for the hobby investor. Financial firm expertise on this subject costs money and fees can affect the profits gained. TECHBOOK is therefore giving a small crash course for beginners.
What is an Exchange Traded Fund (ETF)?
Passive investing in Exchange Traded Funds, or ETFs for short, is an alternative to active investing in the stock market. As the name suggests, these are funds in which a large number of people invest in a financial resource in order to increase their savings over the long term. Unlike active funds, ETFs do not have a lead fund manager. That means there is no person in exchange traded funds who actively makes decisions about which stocks to buy or sell.
Rather, an ETF maps a specific stock market or industry by holding stocks from specific companies. To do this, an ETF is based on stock market indices, which summarize data from shares in an index. Well-known examples of a stock index are the German DAX or the American S&P 500.
How do ETFs work?
The financial world uses the indices just mentioned to map stock markets or an industry. These include sub-segments of markets, entire countries, continents or even the entire world. In an index, shares of companies are bundled according to certain criteria. This bundled information of an index includes, for example, details about the share prices of the 500 strongest American companies on the stock exchange.
The DAX includes the 40 strongest listed companies in Germany. But there are also indices for specific sectors such as wind power or other sustainable technologies. So an ETF takes that information and tries to use it to replicate the market. That means, for example, he automatically buys the shares of the strongest American companies with the money from all members of the fund. The purchase takes place strictly and automatically according to the data of the index.
What are the advantages of ETFs for hobby investors?
Especially for investors with limited resources who invest more as a hobby, ETFs offer an opportunity to invest money in the stock market over the long term. Passive investing has a number of advantages.
Risk reduction through broad investments
In the financial world, people like to talk about diversification to avoid the risk of losing their money completely. This means that the money invested is not concentrated on a single investment idea or company, but on several investment projects. ETFs offer a variety of options to ensure a broad diversification of the invested assets.
On the one hand, there are ETFs such as the MSCI World, which contains around 1,600 of the world’s most successful companies from 23 countries. If there are crises and fluctuations in the stock market of individual countries, these can be offset by stable stocks in the fund.
On the other hand, there are also special ETFs that contain fewer companies and reflect special sectors of solar energy or robotics. Accordingly, these smaller areas contain fewer companies and stock price fluctuations during industry crises can be larger.
Cheap and transparent
The financial industry offers a variety of financial investment products and investments that have been repeatedly criticized for their complexity and hidden costs. Especially with long-term investments, fees and running costs are a factor that should not be underestimated, and they reduce profits in the long term.
Information about the added value of the financial investment and the comparability of the costs contained in the financial products are therefore of great value. As exchange-traded funds, exchange-traded funds are subject to regulations and are therefore largely transparent. The information about the individual ETFs is freely available on the Internet.
ETFs are easier to trade on the stock exchange
With an ETF, when shares in a fund are bought or sold, this can be done easily on the stock exchange. Unlike conventional funds, which have to be returned to fund companies at specific times, an ETF is traded during stock market hours.
The invested assets of the investor are also special assets of the corporation and are managed separately from the business assets of the ETF provider. This means that the investor keeps his shares even if the ETF provider goes bankrupt.
Clear and automated rules
ETFs follow an index and try to map it automatically. Shares in the strongest companies are therefore repeatedly bought or companies that fall out of the index are sold. Depending on the industry or market selected, you do not need any prior knowledge to understand the ETF’s purchase decisions. In addition, there is no change in the fund strategy because the index specifies the companies in which investments are made.
Procedures are becoming increasingly simple
Access to the stock market has been greatly simplified for normal small investors. While in the past you opened a securities account at your bank or a stock exchange dealer where you had orders executed, personal access has now improved. Now you can trade shares, ETFs and other financial assets on the stock exchange with your smartphone and the corresponding app.
The costs are very low and often only amount to a small fee per purchase or sale. Well-known apps that also trade ETF’s are the brokers Trade Republic or Scalable capital. The banks have followed suit and some depots are also available there under favorable conditions, but sometimes charge significantly higher fees than the neo-brokers.
Also read: What is the best app to buy ETFs with?
What are the disadvantages of ETFs?
In addition to the advantages mentioned, investments in ETFs also come with risks and disadvantages. Even with extensive information, investments in the financial market are unpredictable. You should therefore only invest assets that you can do without in the near future.
ethical concerns
The advantage of broad diversification is also a disadvantage of ETFs. Because if you invest in an entire market or in the strongest listed companies in the world, you have a large number of companies with you that are known for environmental scandals, overexploitation and industries with exploitative or poor working conditions. Accordingly, when you buy individual ETF shares in your portfolio, you can have companies that make their money from nuclear energy, oil, alcohol, cigarettes or weapons.
Not every investor wants to make their profits with the help of such corporations. There is also a sustainable variant of ETFs, such as the World SRI. There are companies that have been found to be sustainable and that meet the environmental and social criteria of the ESG standard. But these ETFs also contain companies such as Coca Cola or Tesla, which, as large corporations, repeatedly clash with environmental groups and social movements.
Market price risk and firm investment decision
The value of an ETF depends on the development of the respective index. This, in turn, is influenced in its entirety by the summarized fixed assets that it depicts. So when stocks are included in an index, it can also fluctuate when stock markets fall.
ETFs are therefore also a risky investment instrument, albeit to a limited extent. With the passive investment strategy, you can only react to changes in the market if you actively suspend the savings plan. When the market changes, the ETF responds without actively trading. It is strictly adhered to the index. However, this is also an advantage of ETFs. You don’t have to actively monitor the market and react to fluctuations in the daily rate. The ETF invests at fixed times, so a setback in the index can also mean that you buy a correspondingly larger share of the fund.
Also interesting: Prepare for retirement with your smartphone now
No voting rights at the shareholders’ meeting
Anyone who invests passively in ETFs also gives their voting rights to the fund company of the ETF provider. Thus, as a “small” investor, you can no longer actively intervene in the corporate strategy. On the other hand, those who actively own shares in individual companies support a specific company and its business model with their investment. This conscious decision for individual companies is omitted with ETFs – and with it the right to vote.
Theme ETFs are speculative and risky
If you still want to invest in certain sectors or in a special idea, you can use theme or niche ETFs. However, they can experience liquidity bottlenecks in the event of a crisis. This means that if you sell shares in the securities on the stock exchange, you will no longer get any money because there is no longer any demand.
Crypto ETFs, indices with commodity companies or private equity ETFs in particular should be treated with caution because they attract speculators and can therefore be subject to strong fluctuations. The topic of private equity means investing in companies that are active in the area of company acquisitions and takeovers.
counterparty risk
When an ETF tracks an index, it is common practice to make direct investments in the stocks of the index. So-called physical ETFs replicate the index by buying shares. But there are also synthetic ETFs. Instead of investing in the values of the indices, replicas can also take place through an exchange transaction between fund companies and banks.
These funds, also known as swaps ETFs, carry the risk that a partner in the swap transaction will go bankrupt. The risk increased in this way is also called counterparty risk.
For whom are ETFs worthwhile?
ETFs are worthwhile for those interested in finance who want to start investing their money without relying on individual companies or business models. Unlike short-term trading, ETFs are primarily long-term investment opportunities. It is also not necessary to constantly keep an eye on share prices.
Although ETFs are also high-risk investments, the large number of investments in different company shares creates broad diversification. In this way, the risk is distributed across different markets and sectors, depending on the ETF. ETFs can also be part of a savings plan. This also makes it possible for a small investor to invest a certain savings amount in ETFs every month.