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Erscheinung:03.07.2017 | Topic Investment funds, Consumer protection Exchange-traded funds: ETFs in the low interest rate environment – a secure alternative?

Exchange-traded funds (ETFs) are a hot topic in investment advice at the moment. The reason for this is simple: Germans are well known for their love of saving money and their cost-consciousness, so many investment advisers believe that ETFs are a perfect fit to their needs.

But do the much-vaunted advantages reflect the full potential of ETFs? What opportunities and risks do ETFs entail? And are they really the magic wand to wave against the low interest rates for investors? This article seeks to provide an insight into these questions.

Low interest rates: looking for alternatives

For a number of years now, interest rates worldwide have been extremely low. German retail investors are particularly hard hit as they traditionally tend to invest their money more conservatively, i.e. in current and savings accounts, in private pension insurance schemes and endowment life insurance policies with guaranteed interest as well as in property. The financial markets watchdog (Marktwächter Finanzen) of the consumer organisations sees the reason for this in the marked need for security of German retail investors and their lack of knowledge of alternative investment products. (Special investigation of the financial markets watchdog, pages 15-17.)

In the current environment of persistently low interest rates, this cautious attitude inevitably leads to lower or no investment income at all for retail investors. In the worst case, i.e. if the inflation rate is higher than the nominal interest rate, it could even lead to a loss of purchasing power – a scenario known as "cold expropriation of savers".

Against this backdrop, consumers are increasingly searching for more profitable alternatives for their investment, with many of them discovering the investment opportunities stock exchanges have to offer.

Definition:Exchange-traded funds

An exchange-traded fund (ETF) is an investment fund that is traded on a stock exchange. Most ETFs are passively managed index funds, which means that they use a stock exchange index as their benchmark.

Investment in funds

Even though most German retail investors are sticking to the aforementioned traditional investment products, some are deciding to invest their capital in a fund for the first time. By buying fund units, they usually buy co-ownership of a large basket whose contents are managed by a fund manager whose job it is to manage the fund in such a way that the value of the basket and, thus, of the individual fund units increases.

Funds launched for retail investors whose fund units can be returned during the term of the fund are called open-ended investment funds, open-ended investment undertakings or open-ended retail funds. This group includes for example equity funds, whose baskets consist of shares, bond funds, which mainly consist of fixed-interest government and corporate bonds, and real-estate funds whose baskets comprise residential and commercial property.

For some time now, retail investors have been focusing in particular on index funds. Index funds use stock exchange indices such as the German stock index DAX or the Dow Jones as a benchmark and try to replicate their components as closely as possible. Most of these funds are exchange-traded. Usually, investors can buy and sell these ETFs on the stock exchange via their usual bank.

However, not all ETFs actually replicate the stock exchange index with the securities which belong to it (physical replication). They often also use so-called synthetic replication. When using this strategy, the ETF invests in assets that have no or only a small link to the underlying index. As an accompanying measure, swaps are entered into where the performance of the investments is exchanged for the performance of the desired index. The fund transfers the yield of its basket not replicating the composition of the index to a contractual partner, most of the time its parent company. In return, the contractual partner undertakes to transfer the performance of the benchmark index to the fund. ETFs using synthetic replication are therefore regarded as more complex and riskier in comparison with ETFs using physical replication as they may comprise components that are not even roughly equivalent to the benchmark index.

Advantages of ETFs

Notwithstanding the above, volumes invested in ETFs have risen continuously. In the last decade, the market for ETFs has experienced a real boom, because ETFs have a number of decisive advantages over "traditional" investment funds.
First, there is the cost advantage: investments in open-ended investment funds generally entail various charges and fees, for example in the form of a sales charge on purchase, a management fee, a depositary fee and, if applicable and depending on the performance, a performance fee. The amount of these charges can significantly influence the investment performance. The cost advantage ETFs have as compared with traditional funds results, among other things, from the fact that no sales charge or redemption fee has to be paid to the asset management company on the purchase or sale of the ETF on the stock exchange. In addition, the management fee for passive management is usually much less than it is for actively managed funds. Consumers can find information on costs in the sales prospectus and in the key investor document (KID).

Another advantage of ETFs is their transparency. As they are exchange-traded, consumers can fairly easily find out the price of their ETF fund units during the opening hours of the stock exchange, whereas the price for fund units in traditional investment funds is normally determined only once a day.

ETFs moreover allow for greater flexibility. Thanks to the almost permanent opportunity to buy and sell fund units on the stock exchange, consumers can align their investments with changes in the environment or their personal preferences any time they want. Additionally, there are a number of order types that can be used for trading ETF units, comparable to those offered in stock trading. Investors can, for example, set a maximum price they are prepared to pay for the unit (order type "limit") or trade their units without setting a price (order type "market order").

As mentioned above, ETFs using physical replication are linked to a benchmark index. The individual components or rather the assets contained in the ETF are therefore usually comprehensible. The same does not apply to the ETFs using synthetic replication, however. Depending on its composition, an ETF on the DAX may comprise securities not even contained in the DAX.

One of the most important reasons to invest in funds in general is the allocation of the capital invested to a basket. By diversifying the investment in different investment classes, risks may be reduced and comparatively secure and stable portfolios created. ETFs offer risk diversification by tracking the index. As a rule, the following applies: the broader the index, the greater the diversification. However, risk diversification does not guarantee investment success, as prices can, of course, also fall – regardless of whether investors have their investments managed actively or passively.

At a glance:Advantages and risks

Advantages:
- costs
- transparency
- flexibility
- comprehensibility of components
- risk diversification

Risks:
- market and price
- expense
- liquidity
- risk from diverse composition
- other

Risks

Like other investments, ETFs cannot avoid the rules of the market, so it is important for retail investors to know the risks. Some of them are mentioned below, but the list is not exhaustive.

ETFs and the indices they replicate are primarily dependent on economic conditions and changes such as those of the business climate and policy decisions. Thus, they are naturally subject to fluctuations in value. These can be smaller than in the case of investments in single shares due to the diversification of risks, but the price of an ETF unit still depends on the performance of the individual components of the fund. It is therefore also possible for investors to lose money when investing in ETFs.

The fact that trading in ETFs entails relatively low overall costs should not belie the fact that expenses in connection with the purchase of the units still need to be paid. Even with ETFs there may be costs that significantly influence the final investment performance, such as commissions, sales charges and direct trading fees. In addition, lower costs do not automatically imply a better investment performance than, for example, a traditional investment fund where a fund manager actively tries to achieve a better performance.

An ETF's degree of liquidity depends on the assets it holds. That is why ETFs are generally deemed to be liquid, even though they hold lower cash reserves than traditional investment funds. However, when choosing an ETF, retail investors should look carefully at whether they will really be able to sell their units any time at a "fair" price, for example, even during market turbulence, as not all ETFs trade large volumes of their units every day. Some ETFs only have a low trading volume per day so it might be difficult to find a buyer or seller for the units to be sold/bought. This is especially the case with smaller ETFs, which sometimes track rather unusual reference values. Investors should therefore get information on the ETF's reference values and examine whether they, too, are liquid before buying an ETF.

Even if two ETFs are following the same market or industry, they do not necessarily have to use the same reference values. The funds' components may vary and may be weighted differently. This can entail additional risks which are difficult to evaluate, such as those arising from securities lending, leverage transactions and short selling.

Depending on the composition and investment strategy of an ETF, there may be further risks, such as counterparty risks, currency risks or the risk that trading may be suspended.

Note:Further information

You can find more information on this topic on the BaFin website (only available in German).

Tips for consumers

There is no such thing as the perfect investment that offers maximum security, can provide short-term liquidity and at the same time fulfils the promise of maximum returns. What is generally true for all investments is that potentially higher returns have to be "paid for" with less security. Retail investors face this problem too and therefore have to decide for themselves which risks they are prepared to take in return for potentially higher interest rates. It is particularly important in this context for them to clearly define their own investment objectives and their investment horizon.

For retail investors with a long-term perspective the principle of risk diversification is of foremost importance. They should not "put all their eggs in one basket", but instead spread their capital across different products, such as term and overnight deposits, current accounts, pension and life insurance schemes and, in the long-term, also exchange-traded securities and bonds. ETFs can be a useful addition for investors who are prepared to take some risk in exchange for saving costs to increase their capital – especially in times of low interest rates. They should, however, be aware that ETFs can also generate losses and can therefore not replace secure fixed-income investments.

Consumers should also not forget that there are many different types of ETFs. It is therefore important to get detailed information on the functioning and the components of the respective ETFs and the risks they entail before taking an investment decision. Information on whether the ETF uses physical or synthetic replication can be found in the sales prospectus and the key investor document. In addition, investors should take professional advice, because Aristotle's saying still holds true: "for what is improbable does happen, and therefore it is probable that improbable things will happen".

Please note

This article reflects the situation at the time of publication and will not be updated subsequently. Please take note of the Standard Terms and Conditions of Use.

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