ETF Investing:How ETFs Work and How to Choose One

So far, we have explored two main investment paths at Scale & Own. We first learned how to build a cash-flow-oriented strategy using assets such as dividend stocks, REITs, BDCs and bonds. We then took a step towards capital growth by selecting quality companies with our Quality Value strategy.

Both methods require learning how to analyse and select investments individually. However, not every investor wants to devote as much time to studying companies, valuing businesses or actively managing a portfolio.

We are therefore broadening our approach with a simpler, passive solution: ETFs. They do not necessarily replace the knowledge or individual selection we have learned so far, but offer another way to gain market exposure and can serve as a complementary tool.

What is an ETF?

When you buy a share in an ETF, you are not investing in a single company, but in all the assets held by that fund.

To understand this more clearly, we first need to explain what a stock market index is. An index is a benchmark that groups several companies according to specific rules. For example, the S&P 500 comprises around 500 large US companies and is one of the main benchmarks used to track the performance of that market.

You cannot buy an index directly. This is where the ETF comes in:

• The index determines which companies make up the benchmark and their weighting.
• The ETF is the fund that seeks to track that index and whose shares you can buy through your broker.

If, for example, you want to invest by following the S&P 500, you can use an ETF that tracks the index rather than buying hundreds of stocks separately.

Some ETFs track broad market indices, while others focus on sectors, bonds, dividends or particular strategies.

How does an ETF work?

From the investor’s perspective, buying or selling an ETF works in the same way as trading a traditional stock: you can trade its shares in real time during stock-exchange opening hours through your broker.

Behind the ETF, however, is a fund that holds a portfolio of assets according to the rules of the index or strategy it tracks. When you buy a share on the market, you gain indirect exposure to that portfolio.

Practical example: investing USD 100 in the S&P 500

Imagine investing USD 100 in an ETF that tracks the S&P 500. That share gives you indirect exposure to the portfolio of around 500 companies in the index, rather than making you dependent on a single company.

Nor is this allocation divided into equal parts. In most ETFs that track the S&P 500, each company’s weight depends on its market capitalisation, meaning the total stock-market value of all its shares:

• Companies with the largest market capitalisation represent a proportionally larger share of the fund.
• Companies with a smaller weight in the index occupy a much smaller place.

What are the advantages of ETF investing?

Compared with the individual asset selection covered so far, ETFs offer several practical advantages, particularly for those seeking to diversify and simplify part of their portfolio.

Diversification with a single investment

One of the main advantages of ETFs is that they allow you to spread capital across dozens or hundreds of assets through a single position. Because performance does not depend on one company alone, problems specific to an individual business have a more limited effect on the portfolio as a whole.

Simplicity and lower costs

Investing in a broad-market ETF substantially reduces the need to analyse the balance sheets, income statements and valuations of many companies. A single transaction through your broker can give you access to the general performance of an entire market.

In addition, many index-tracking ETFs have low management fees, making highly diversified portfolios accessible at a relatively low cost.

Access to different markets and strategies

Through a broker, ETFs provide access to international markets, particular sectors, fixed-income products, commodities or income-generating strategies.

Many ETFs also publish their composition and the weight of their largest holdings, which makes it easier to check the assets to which you are actually exposed.

What risks and limitations do ETFs have?

The simplicity and diversification of ETFs also have trade-offs. Before using them, you need to understand how much control you give up and which risks you continue to assume.

Less control over the companies you buy

When you invest in a broad-market ETF, you buy “the whole basket”. You cannot choose which companies to include or exclude according to their valuation, quality or business prospects. You will therefore also be exposed to companies that you might not buy individually.

Diversification does not mean an absence of concentration

Even when an ETF contains hundreds of companies, some indices can be highly concentrated in one sector or a small group of large companies. If a few businesses represent a significant proportion of the index, their performance can strongly influence the ETF.

Tracking a market means accepting its valuation

Unlike direct stock selection, which allows you to look for quality companies at attractive prices, an ETF that tracks a traditional index maintains the exposure defined by that index. It does not select individual companies according to whether we consider their share price high or low.

We therefore remain exposed to the valuations of the companies in the index. This is one of the main differences from selecting stocks individually: we gain simplicity and diversification, but give up some control over the quality and price of each company added to the portfolio.

What happens if an asset manager closes an ETF?

Although this is uncommon, an asset manager may decide to close an ETF if it does not reach a sufficient size or is no longer profitable for the manager.

The closure of the ETF does not in itself cause the investment to be lost. The asset manager will generally announce it in advance and may liquidate the fund, reimbursing investors for the value corresponding to their shares, or merge it with another ETF. The size of the fund is therefore another point to examine when choosing an ETF.

How do you choose an ETF?

To select an ETF for your portfolio, it is useful to analyse several fundamental criteria methodically:

This is one of the first points to check because it determines the companies or assets to which we will actually be exposed and, consequently, much of the investment’s risk profile and long-term behaviour.

Two ETFs may appear similar while tracking indices with very different compositions, criteria and levels of concentration.

The TER, or Total Expense Ratio, represents the fund’s annual costs as a percentage of its assets. These costs are deducted directly within the ETF and therefore do not appear as a separate commission paid from our account.

Although the percentage may seem small, it is a recurring cost that should be compared. As a general rule, ETFs that track broad indices have a lower TER than ETFs following more complex or specialised strategies.

It is also useful to examine the assets managed by the ETF and its trading volume.

Liquidity indicates how easily we can buy or sell shares, while the spread is the difference between the available buying and selling prices in the market. A smaller spread reduces the implicit cost of entering or leaving a position.

Size and trading volume can serve as useful reference points, although a larger ETF is not necessarily more liquid in every circumstance.

The dividends generated by the fund’s assets can be handled mainly in two ways:

• Accumulating ETF (Acc): reinvests dividends within the fund. It is generally suited to strategies focused on capital growth.
• Distributing ETF (Dist): pays these dividends to the investor periodically. It is generally better suited to income and cash-flow strategies.

This choice does not change the assets in which the ETF invests, but the way the distributions they generate are managed.

The way the ETF tracks its index can also vary:

• Physical replication: the fund directly holds the assets in the index, either in full or as a representative sample.
• Synthetic replication: it uses financial contracts, generally swaps entered into with another entity, to track the index’s performance without having to hold all its assets.

Synthetic replication can make certain markets or strategies more accessible, but it introduces counterparty risk, meaning the risk that the entity with which the contracts are agreed cannot meet its obligations.

Before buying an ETF, you need to check its listing currency, the exchange on which it trades and the regulatory framework under which it is established.

There is an important distinction here: the currency in which you buy an ETF does not by itself determine the investment’s currency risk. An ETF may be listed in euros while holding, for example, US companies whose assets are mainly exposed to the dollar.

In Europe, many ETFs offered to retail investors comply with the UCITS Directive, a European regulatory framework designed to impose requirements for diversification, transparency and investor protection.

We also need to check that the ETF is accessible to investors in our country and can be traded through the broker we use.

ETFs are created and administered by asset management companies. Some of the best known worldwide include iShares (BlackRock), Vanguard and Invesco, which manage some of the most widely used ETFs in the market.

The asset manager’s experience, its history of administering ETFs and the transparency of the information it provides are other points to consider when comparing similar products.

Finally, you should not choose an ETF simply because its costs are low or it is popular. We need to understand the role it will play in our strategy: providing broad and diversified exposure, focusing on a specific market segment, adding fixed-income products or generating regular income.

This final criterion is particularly important because there are different types of ETF and each can play a distinct role in our strategy.

What types of ETF are there, and what are they used for?

An ETF does not in itself define an investment strategy. Depending on the assets it contains and the rules it follows, it can be used to seek growth, generate income, diversify a portfolio or gain access to particular markets.

Note: the ETFs and symbols mentioned below are educational examples only, intended to illustrate each category.

Broad-market and diversification ETFs

They provide broad exposure to a market through a single investment and often serve as a diversified foundation for a portfolio.

• S&P 500 (for example, IVV): provides exposure to around 500 large US companies.
• MSCI World (for example, URTH): provides diversified exposure to large- and mid-cap companies in developed markets.

Growth and specific-segment ETFs

They allow part of the portfolio to focus on certain segments instead of investing broadly across the market.

• Nasdaq 100 (for example, QQQ): comprises 100 of the largest non-financial companies listed on the Nasdaq and has high exposure to the technology sector.
• Small-cap companies (for example, IJR): provides exposure to US companies with a smaller market capitalisation.

Dividend and income-oriented ETFs

They provide exposure to assets that generate dividends or interest and can be used in a cash-flow-oriented strategy.

• Dividend ETFs (for example, SCHD): invest in a portfolio of companies selected according to dividend-related criteria.
• Bond and fixed-income ETFs (for example, IEF and TLT): add exposure to fixed-income products and the interest generated by the bonds in the portfolio.

ETFs using more advanced income strategies

• Covered calls: sell options on their holdings to generate premiums and additional income, in exchange for limiting part of the upside potential when the market rises strongly.
• Preferred shares: invest in hybrid securities positioned between equity and debt, whose distributions take priority over dividends on ordinary shares.

Your next step with Scale & Own

You now know two different ways to gain exposure to the market. ETFs make it possible to do so simply and with diversification, while selecting stocks individually gives you more control over quality, valuation and the particular companies included in your portfolio.

These approaches are not necessarily mutually exclusive. Their weight in your strategy will depend on your objectives, the time you want to devote to analysis and the degree of control you wish to retain over your investments.

In the next and final lesson in this section, we will learn how to bring together everything we have covered to build different types of portfolio according to your objectives, combining Cashflow, Quality Value and ETF strategies within the overall Scale & Own method.

Continue to the final stage: Portfolio composition

→

• What is an ETF?
• How does an ETF work?
• Advantages of ETF investing
• ETF risks
• What happens if an asset manager closes an ETF?
• How to choose an ETF
• Types of ETF
• Next step with Scale & Own