ETFs explained: How index funds work

ETFs are considered an easy way to invest money on the stock market. But how are ETF shares actually created? Which companies are involved? And how does the whole thing work technically?

According to the German Stock Institute, around a fifth of all investors in Germany save through ETFs – and the trend is rising. Last year, the fund assets of ETFs traded on Xetra reached a new high. Passive index funds are particularly popular with beginners because they are simple products. But how do the processes behind them work – in the “engine room” of the ETF?

What are ETFs?

ETFs (Exchange Traded Funds) are exchange-traded funds or index funds that reflect the performance of an index such as the DAX or the Dow Jones. If the DAX rises by one percent, the ETF on the DAX would also rise by one percent. A DAX ETF usually contains all 40 companies from the index – such as VW, SAP or Siemens.
ETFs make it possible to invest in a wide range of stocks or other securities at any time – even with small amounts. Investors can buy shares using a savings plan, for example.

ETF provider creates and manages the products

With traditional investment funds, the matter is pretty clear: a fund manager uses a strategy to select attractive stocks and avoid unattractive ones. In doing so, he tries to achieve the highest possible profits. With an ETF, however, there is no fund manager who decides every morning which securities to buy and sell. Instead, the index fund “passively” tracks a stock market index, as it is called in stock market jargon.

An ETF is created and managed by the respective ETF provider – for example Deutsche Bank with its Xtrackers brand, Amundi, Vanguard, UBS or Invesco. One of the largest in the industry is the US investment company BlackRock, which sells around 1,400 ETFs worldwide through its iShares brand. There are around 630 iShares ETFs in Germany alone.

ETF providers play a crucial role in the engine room. They are responsible for ensuring that private investors can invest in stock market indices at all. After all, an index is ultimately just a theoretical list, and an investor cannot invest directly in an index, explains Verena Heming, who is responsible for sales to digital business partners such as online banks or brokers at BlackRock, in ARD podcast “Gold & Ashes: Project ETF“.

A stock market index tracks the performance of certain stocks, bonds or commodities and is therefore a barometer for a specific market segment such as industries, regions, countries or topics such as artificial intelligence, climate-friendly energy or health. According to the Index Industry Association, there are over three million stock market indices in total. An ETF provider recreates these and bundles the securities in an ETF that is listed on the stock exchange and receives a securities identification number (WPK). “After a few weeks or months of creating this ETF, the security can then actually be traded on the stock exchange,” says Heming.

Podcast “Gold & Ashes: Project ETF”

In the second season of “Gold & Ashes” the ARD Finance Department In six episodes, the most important things about investing in ETFs are explained step by step – with background information and expert knowledge. Can be heard in the ARD audio library and everywhere where podcasts are available. The individual episodes can be found here.

Episode 1: Why ETFs? (14 August)
Episode 2: Which ETFs are there? (21 August)
Episode 3: Engine Room ETF (28 August)
Episode 4: Risks and criticism of ETFs (September 4)
Episode 5: How do I find the right depot (September 11)
Episode 6: How do I build my ETF portfolio? (September 18)

Two possibilities for replication

There are two methods for replicating an index: With physical replication, the ETF is made up of the original shares on a 1:1 basis. The provider weights the company shares according to the market value – i.e. the number of shares in circulation times the price – as in the index and then buys them (full replication). Physical replication is often “optimized”. Due to the fluctuating market values ​​and weightings in large indices such as the MSCI World, the ETF provider only buys the part of the shares that is responsible for a large part of the performance (sampling). This saves costs and effort.

In synthetic replication, however, the index is artificially replicated through exchange transactions – so-called swaps – between the ETF provider and other financial institutions, usually investment banks. This means that shares are exchanged for other shares in order to achieve exactly the same performance as the index. The basket that the investor then owns can look completely different to the actual index and does not have to contain a single share from it. Instead, the other side only promises that you will get the same return.

Because there are now three parties involved in this deal, there is also a so-called counterparty risk if the additional financial institution goes bankrupt. Once the ETF provider has selected the method to use to track the respective index, it still has to decide on which stock exchanges the ETF should be listed. “We are definitely interested in making the ETF available and bringing it to as many stock exchanges as possible. But of course that also means listing costs,” explains Heming.

Index provider reconsiders the methodology

The methodology behind an index – that is, how it is composed, who calculates it and how often it is updated – comes from an index provider; for example MSCI, S&P, Stoxx, Dow Jones or FTSE. But there are also many smaller ones. One of them is Solactive. The Frankfurt-based company has created and manages a total of more than 30,000 indices.

Timo Pfeiffer, Chief Markets Officer at Solactive, explains the business model of an index provider as follows: “I try to help the respective ETF provider to launch the ETF and then make it available to investors at the end.” Solactive provides them with the index and the data, for which the ETF provider pays a license fee. Similar to the DAX, the Solactive Germany Index, for example, tracks the stock market performance in Germany. The company itself obtains the data from the stock exchanges and pays for it.

ETF and index providers occasionally work together to develop new indices and ETFs. In doing so, they take trends and global developments into account, but customer requests are also crucial. “We focus on the needs of our customers,” says Verena Heming of BlackRock. As long as these desired concepts are not niche products that only a few investors would use, it is worth discussing new indices with the index provider. These do not have to be approved individually because the providers are controlled as a whole. They are subject to European benchmark regulation: This is a construction of the EU – a kind of driving license.

Weighting is reviewed every quarter

For a larger market, drawing up an index can be quick and take just one day, says Timo Pfeiffer of Solactive. For more complex indices, however, the team may need several weeks. In addition to criteria such as the region or size of the company, the industry in which the company operates also plays a role in the selection process. This selection is continuously reviewed for existing indices – usually quarterly or every six months. The index provider and the ETF provider must publish the methodology transparently for all investors to see.

The last step in creating a stock market index is typically weighting, says Pfeiffer. The most common way to weight a stock is by market capitalization, i.e. the stock market value, although individual positions are sometimes capped. Which companies end up in an index and how heavily they are weighted is therefore decided by the index provider’s employees in consultation with its customers or independently.

Once the index has been created, it runs automatically and the performance is updated every 15 seconds, for example. The calculation is made using a corresponding database, all based on special software. If the indices are then checked for weighting every quarter and the companies are selected again, the ETF provider’s portfolio team must also recreate the new catalog, also known as “rebalance.”

Reinvest dividends directly or have them distributed

The income or return from ETFs is mainly made up of price increases. If the shares in an ETF increase in value, the value of the ETF also increases. In addition, there are dividends, the profit distributions from companies. However, not every ETF pays them out to private investors. This depends on the so-called use of income.

There are distributing and accumulating ETFs. The dividends, which most companies pay out once a year, are either paid into the investor’s account as a sum of money or are directly reinvested in new ETF shares. The advantage for holders of accumulating ETFs is that the dividends do not sit around in a clearing account or are spent – a kind of self-discipline for saving.

In case of doubt, an accumulating ETF is more profitable because the dividends are directly compounded and the money therefore grows faster. Of course, investors can also simply reinvest their dividends themselves, but this is complicated and an extra transaction fee must be paid. The advantages of distributing ETFs are the ongoing income that you see in your own account. With most ETFs, you can choose between the two options.