Why Everybody’s Talking about ETFs And What Makes Them Different from Shares And Funds

2020 has been a turbulent year. Covid-19 celebrated its existence, and with it came a change of almost every belief we used to feel comfortable having. One of them: My job is safe and I just need to work to be able to maintain my lifestyle.

Well, now that this is down the drain, people, companies and magazines everywhere in the world suggested different solutions to this very simple problem: How can we feel financially secure, when really nothing is anymore? One answer has been especially successful: Invest in ETFs. That’ll do the trick.

But although everybody seems to talk about ETFs, not many really know what stands behind that name. So in this article we would like to change that. You will get an overview over shares, funds, different kinds of funds suitable for a long-term investment and, last but not least, ETFs. Here we go.

 

Shares – Your Very Own Part of a Company

In order to make you understand ETFs, we have to start at the beginning: the shares. Shares are teeny-tiny parts of a company. Let’s say you own a share of SAP. This means you may own one doorknob in their headquarters. This does not give you the right to, let’s say, paint the doorknob pink, but it let’s you participate in the ups and downs of the value of said company.

metal doorknob on a turqouise door

Owning shares is like owning very little parts of the company – like a doorknob | Photo by Antonina Bukowska on Unsplash

If SAP does a good job, their market value will increase. If this happens, your doorknob also becomes more valuable. If you cash out now, so sell your share, you will get back more than you invested. But the opposite can also happen: Due to mismanagement, an economic crisis or just bad press SAP’s market value might decrease. In this case, the value of your doorknob also goes south.

If your doorknob company doesn’t recover after a crisis, it will go broke. And in conclusion, you will go broke, too, if you had invested all your money in shares of just this one company. This is why spreading is key. You need to buy shares of multiple companies in order to spread your risk. So when one company you have shares of goes broke, the others can help you cover your losses. In other words: Never put all your eggs in the same basket!

 

Funds Make you Spread Your Risk

A fund is like a big bowl of soup, with the only difference being that the ingredients are different investment types, like shares of companies.

Bowl of pumpkin soup on table

Investing in a fund is like adding water to a soup | Photo by Monika Grabkowska on Unsplash

 

If you invest in a fund, you add water to the soup. This water will now mix and match with all the ingredients a.k.a. shares of companies, taking over their colour, fragrance and taste, so when you ask for a spoon you will enjoy tiny bits of every ingredient.

By investing in a fund, you follow investment-rule number one: Spread your risk! If one company goes broke, your loss will be to a minimum, because by investing in a fund you automatically invested in multiple companies. You didn’t even have the chance to forget this rule. This automatic safety belt makes funds a perfect instrument for long-term investors with or without stock market knowledge, such as everyone and their neighbour wanting to build up money for their old age.

These bowls of soup exist for pretty much every region, country or economy. With just three funds a stay-at-home wife could invest in China, the 30 most successful tech companies all over the world and small companies in Germany. If this isn’t spreading your risk, we don’t know what is!

 

Different Kinds of Funds for Long-Term Investors

Until now we’ve just spoken about investing in companies. But the investment world is way bigger! It is so big indeed, that we can’t cover all there is, but will focus on a) different kinds of funds that are b) suitable for long-term investments.
 

  • Equity fund/mutual stock fund

Funds that invest in companies by buying shares of said companies. So those funds we just discussed.
 

  • Bonds

Funds that invest in depts of companies or countries. Private and/or institutional investors lend e.g. the German state money and get a payback-promise plus a fixed interest rate in return.
 

  • Real estate fund

Funds that invest in real estate. The payback is by participating in rents or revenues.
 

  • Fund of funds

Funds that invest in other funds. By investing in a fund of funds, you spread your investment even further than with a „normal“ fund, but transparency goes down.
 

  • Mixed fund/Balanced mutual fund

Funds that invest in different types of investment classes in one fund, like companies and depts.
 

  • Guarantee fund

Funds that guarantee you a payback of a certain amount of your money at a specific time.

 

Magnifying glass on word etf before a graph background

ETFs are a good addition to any long-term investor’s portfolio

ETFs – The Solution to All Our Problems?

Now we’re finally at the point where we can talk about ETFs. Because ETFs (short for Exchange Traded Funds) are like normal funds with but one major exception: They don’t have a manager.

This lack of a person to do all the buying and selling leads to multiple smaller differences.

For one, ETFs are cheaper. If you don’t have to pay a manager, you can cut most of the expenses. An ETF comes at around one tenth of the costs of a managed fund.

Secondly, the ETF can’t act. It just follows the market. By market we mean this ziggy-zaggy graph that brokers yell at in those old stock-market movies. It is called an index. An index is a summary of a certain market. The DAX for example is the combined performance of the 30 biggest German companies. Same goes with the Dow Jones in the States.

Thirdly, because an ETF has to follow an index by definition, investors can only participate in markets that already exist. This might sound weird at first, so let us explain: A fund that is run by a fund manager can invest in any company, real estate or country there is. By picking their favourites, fund managers can create their own markets and come up with truly unique portfolios. An ETF can’t do that. If you invest in an ETF that covers the Dow Jones, you invest in every company that is a part of the Dow Jones. There is no cherry picking. So if you invest in an ETF, your investment choices are more limited than when you choose a managed fund that has exactly the portfolio of companies you want to invest in.

 

In conclusion, ETFs are cheaper than managed funds and, when you invest long-term, just as profitable. And this is also the reason why so many financial advisors, journalists and companies sell them as the one-and-only investment for retirement saving plans. But nothing is just perfect and neither are ETFs, because they limit your investment choices. Their overall characteristics make them a valuable part of any long-term investor’s portfolio, but they are not the holy grail.

If you’re looking for more information, come to one of our workshops! We’d be happy to see you there 🙂

Best,
Verena + Yve

0 comments on Why Everybody’s Talking about ETFs And What Makes Them Different from Shares And Funds