FAQ about Exchange Traded Funds investing – ETFs

Why are Index funds smart bet

The way how Exchange Traded Funds work seems pretty straight forward at first. But when you start trading or investing in ETFs you then understand that there are a lot of technicalities associated with it. For this reason, I decided to create an FAQ based on my personal experience investing in ETFs. 

Do ETF pay dividends?

The easy answer is: “Yes, ETFs pay dividends”. The more complicated, but accurate, answer is “It depends”. Almost all ETFs pay dividends, the question is rather whether you will see or not those dividends paid to your broker’s account. A distributing ETF will be paying you a dividend on a regular basis, either monthly, quarterly, half-yearly or yearly. An accumulating ETF on the other end will also pay you a dividend, however, the dividend will not be paid to your broker’s account. In case of an accumulating ETF, the ETF emitter will keep the dividend and use it to buy shares of that same ETF on your behalf. 

Accumulating or Distributing ETFs, what is better?

There are two main types of ETFs. Accumulating ETFs and Distributing ETFs. Which one is better depends on your investor profile. If you want to still keep control of your portfolio, I recommend distributing ETFs so that you can keep the flexibility to decide where to reinvest your dividends. Distributing ETFs are also better if you want to live on your dividend whereas you will have to sell your accumulating ETFs in order to use them for your retirement. 

What does ETF physical replication mean?

A physical ETF provider will physically hold (as opposed to synthetic ETFs) the shares of the Index constituents it aims to replicate. To use other words, physically-backed ETFs execute their investment strategy by buying and selling the underlying shares of the said index.

Let’s consider the DAX Index for a second, which is made of the 30 highest capitalization securities in Germany. A physical DAX ETF will own, in the same proportion, shares of the 30 highest capitalization securities in Germany. If one security leaves the index because of low market cap performance, then the ETF automatically sells its position and vice and versa. 

Example: In the DAX index, the weighting of Linde PLC is (as of 13.4.2020) 9.48% (see börse.de) an ETF replicating the DAX would aim to keep its physical holding of Linde PLC as close as possible to 9.48% (Ex: Ishare Core Dax ETF shows 9.78% of Linde PLC). The small delta between 9.78% and 9.48% comes from the lag between the recalibration of the ETF against the real DAX index.

When to pick physical replication over synthetical replication?

  • When Index constituents are in large and liquid markets. Physical replication requires frequent recalibration that happens through buying and selling index components. If index constituents are in a high fee or illiquid market, the physical recalibration will be more labour intensive and costly. It could be beneficial to pick physical replication in liquid and low fees markets.
  • When the number of index constituents is low. The Dow-Jone only have 30 constituents, same for the Dax index, therefore the recalibration only requires a maximum of 30 positions to modify. In the case of the MSCI world for example – which is made of 1600 securities, recalibration can mean up to 1600 position to modify to fit the index weighting.
  • When you want to know what you own. It depends on your investor’s profile but generally, people seek transparency in their portfolio. Physical ETFs are highly transparent as they own, in the same proportion the stocks making up the index. However, in the case of synthetic replication, the ETF emittent might end up holding a completely different basket of stocks compared to the index. For example, the Lyxor MSCI India which replicate the performance of the MSCI India index does not own a single Indian stock. The ETF replicates the performance of the MSCI India index by trading French stocks (Lyxor is operated by a french bank – Société Generale.) such as: “Danone, Sanofi, Schneider Electric, Total etc… This strategy allows the ETF emitter to offer lower fees, but the bottom line is that you want to invest in India but end up owning french stocks.
Synthetical ETF replication - Example of MSCI India with swap contracts using french stocks
Synthetical ETF replication – Example of MSCI India with swap contracts using french stocks. Source: Lyxoretf.de

Can an ETF go bankrupt?

No, an ETF is a financial product so it can technically not go bankrupt. Only companies can go bankrupt. However, an ETF emitter can go bankrupt, or, an ETF emitter can decide to close an ETF.

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