How to find the right ETF in a few steps

You know that you want to invest passively and build assets. And you want to become active now. But the selection of a good 1,500 index funds with cryptic names and lots of information seems incomprehensible to you? The good news is that it is not that difficult.

There are three things investors should pay attention to when making long-term investments, then nothing can go wrong: broad diversification, a sufficiently long investment horizon and the lowest possible costs. The first two points allow for a relaxed approach to price and default risks and excessive costs eat up profits.

This makes ETFs the ideal investment instrument for beginners, as they are also very easy to understand, especially the simple index trackers of the first generation.

Step 1: Choosing the asset class

Asset classes are various objects in which you can invest and which usually differ in yield and risk behaviour. The most important are equities, i.e. shares in companies, bonds and fixed-term deposits, commodities and precious metals, real estate. Art, vintage cars and wine as investments are also asset classes. At this point, however, we limit ourselves to direct investment opportunities on the stock exchange, specifically shares, bonds and commodities.

For example, if you choose shares now, there are still 1,000 ETFs to choose from.

Step 2: Choice of market: region, country, industry

The second step is to consider which market you want to invest in, a single country (USA), a region (such as the Pacific) or the entire world. You may also want to focus on one industry (e.g. pharmaceuticals, gold mines or IT security).

Step 3: Broad-based or focused?

The third step is not far from the second. This is about the strength of the diversification. If you want to invest globally, you can do this with ETFs containing around 1,600 companies from industrialised countries worldwide (MSCI World) or you can orient yourself even more broadly in ETFs containing around 3,500 shares from industrialised and emerging countries (MSCI World All Countries, FTSE World All Countries). In contrast, the DAX, with the 30 largest listed companies in Germany, is quite poorly diversified: one country, large companies, few sectors.

As a general rule, the sharper your investment focus, the greater your opportunity, but also your risk.

Step 4: Distributing or accumulating

The next step is for you to decide whether you would like to have current income from the ETF such as dividends or interest paid out regularly. Or whether these automatically remain in the ETF and thus increase the fund's assets. This is called reinvesting and, in your view, represents a reinvestment. It increases the value of your shares.

Distributing or reinvesting is a question of your personal preference. If you choose a distributing ETF, you can regularly inform yourself about

Cash injections. ETFs usually distribute income four times a year. However, withholding tax is immediately payable on the inflows. If you want to build up assets over the long term, reinvesting ETFs are more advantageous. You do not have to reinvest the income to benefit from compound interest (also applies to dividends).

Step 5: With or without currency risk

If you are an investor from the euro zone investing in foreign stocks, for example US companies in the S&P 500 index, your return depends not only on the price development but also on the exchange rate development of the euro against the US dollar. This can be to your advantage or disadvantage. In any case, there is another influencing factor that can easily be avoided, as most standard ETFs are now available in a currency-hedged version. With these, the providers minimize currency effects, the costs for which are included in the total cost ratio.  

In the long term, the exchange rate effects of most currencies balance each other out again. Whether you choose a currency-hedged ETF depends primarily on whether you want to avoid the additional source of volatility in your ETF.

Step 6: Replication method

There are various methods of how ETFs track an index. Most buy the securities in the index, they are fully replicating. Others buy only the largest securities, this is called 'partially replicating' or 'optimized'. With very large indices, this makes sense because constantly adjusting the portfolio around small, little traded securities would be by heart and therefore expensive.

The third form is synthetic ETFs, also known as swap-based. With these ETFs, the providers buy various securities and balance out the performance with third parties via contracts for difference, swaps. The form of mapping was critically discussed a few years ago, as risks arise from the possible default of the swap partners, called counterparties. Although the share of a single counterparty is limited, there can be several.

The bottom line: If you feel uncomfortable with the idea of having Chinese bonds in your fund assets instead of, for example, DAX shares, you can select specifically replicating ETFs. That is the majority anyway.

Swap-based ETFs also have advantages. For example, they allow investments in companies from countries where foreign investors are only allowed to buy shares to a limited extent or not at all, such as Vietnam.

Step 7: Choose the ETF

Once you have reached this step, there should not be many more to choose from. Now you can choose a specific ETF.

One possible decision criterion at this point is the lower total cost ratio.

Another is size, i.e. the assets under management, also known as assets under management or AUM for short, and available on boerse-frankfurt.de. ETFs are occasionally closed or merged if they are not worthwhile for the issuers in the medium term. The providers' profit margins are very small (which means low costs for you) with high economies of scale. Issuers declare that an ETF is worthwhile from 50 to 100 million euros of assets under management. Closure means a new investment decision for investors and the taxation of accrued profits. Keep this in mind when using size as a criterion: Theme ETFs tend to be smaller and some ETFs are still very young.

Another tip: go to the ETF provider's website. There you can view, for example, the detailed composition of the ETF, sometimes also a graphically prepared distribution by country or sector. Which issuer suits you best can also be a criterion for deciding between ETF A and ETF B.

Step 8: Lean back and relax

If you are making long-term investments, the long-term price trend is also the relevant one for you, not the short-term price fluctuations. Several studies have shown that private investors often lose money in the first year of their ETF investment because they try to beat the market. Very few people succeed. The timeless advice of world-renowned investor Peter Lynch applies to the success of long-term investments: "It is not about timing the market but time in the market - it is about how long you are invested, not about beating the market.