HOW DO ETFs WORK?

Marketing information | Investment risk

An index is a collection of securities that is intended to represent a specific market or market segment. An index is a theoretical concept and a barometer for the change in the positions contained in the index over time. An index can be as broad as the entire US stock market or as narrow as a single country or industry. Indices are created by index providers such as MSCI, Dow Jones Company or SIX Group AG.

• MSCI (Morgan Stanley Capital Investment) e.g. MSCI Acwi, MSCI World
• SIX GROUP AG e.g. SMI, SLI, SIX30
• Standard & Poor's e.g. S&P
• FTSE Group e.g. FTSE 100
• Dow Jones Company e.g. Dow Jones
• Nihon Keizei Shimbun e.g. Nikkei

When creating an index, the providers define a wide range of criteria that the values in the index must fulfil in order to be included. The large number of criteria and combinations also explains why there are so many indices. Possible criteria are, for example

• Asset class such as equities, bonds or commodities
• Countries and regions such as America, Germany or even the whole of Europe or emerging markets
• Industries or sectors such as the tech or consumer goods industry
• Certain strategies that address specific topics such as sustainability

ETFs are a financial instrument that makes the various indices investable. ETFs attempt to replicate the index on which they are based as closely as possible. Once an index provider has created an index, ETF providers such as iShares can issue the appropriate ETF. This is then given a security number (VALOR) so that it can be clearly identified. The ETF can now be bought and sold on each trading day without a front-end load.

For example, with the iShares Core S&P 500 UCITS ETF you invest in 500 of the largest listed companies in the USA. As a result, you can spread your investment more broadly and thus reduce risks in the long term. Please note, however, that diversification is no guarantee against capital loss.

Put simply, there are two different ways of replicating an index: A distinction is made between physical replication and synthetic replication.

• Physically replicating ETFs: Physically replicating ETFs hold the securities of the index they are replicating. Two methods are used to replicate the index: firstly, full replication, i.e. the ETF holds all securities in exactly the same weighting as the index, and secondly, partial replication, in which only parts of the index securities are replicated in the ETF. The latter is used, for example, for very broad or illiquid indices, i.e. whenever the costs of fully replicating the index could have a negative impact on the ETF's performance.
• Synthetically replicating ETFs: A synthetic ETF does not hold the securities of the index, but a financial derivative, usually a so-called swap. Such a swap agreement stipulates that the ETF receives the return of the reference index from the counterparty, but minus additional variable costs, the so-called swap spreads, which generally depend on the current market conditions. Derivative-based ETFs offer the opportunity to invest in markets that are difficult or impossible to access for physically replicating funds, such as commodity markets or certain emerging markets.