ETFs: how they work, physical or synthetic replication, what are the fees?

An ETF, also called a tracker, is an index fund: it aims to track the performance of a stock market index as closely as possible. It is traded on the stock exchange like a share. There are two ways to track the index: physical replication and synthetic replication. According to the AMF (French Financial Markets Authority), the fees for an ETF are "often less than 0.5 per year," compared to fees "greater than 1 per year" for a traditional actively managed fund. These are approximate figures: a given ETF may have higher fees. Investors can lose all or part of their invested capital.

This page describes how an ETF works, its replication, fees, and risks. It does not address ETF taxation, which depends on the investment vehicle in which it is held. It does not provide a list of ETFs, the fees of any particular ETF, or a list of ETFs accepted in a French equity savings plan (PEA).

What is an ETF?

A traditional fund is managed by a team that selects its securities. An ETF does something different: it sets a benchmark index, for example a stock index, and seeks to replicate its performance. This is what is called an index fund.

Three key points to remember, according to the AMF:

• It is traded continuously. It can be bought or sold throughout the entire trading day.
• Orders are processed through a financial institution. You give your orders to him, as if for an action.
• It can be held in a regular securities account. The AMF cites ETFs, or trackers, among the instruments that this account can contain.

The AMF also distinguishes between distributing ETFs, which pay dividends to investors, and accumulating ETFs, which automatically reinvest them. The taxation of these two types of ETFs is not addressed here.

Physical or synthetic replication

Replication is the way in which the ETF replicates its index. The AMF describes two mechanisms.

This page does not classify the two mechanisms: the choice depends on the index followed and your situation, and it is made on the documentation of the ETF concerned, including its key information document (KID).

The costs: an order of magnitude, not a fixed scale

The AMF provides two benchmarks, which are orders of magnitude:

The word "often" is important: these benchmarks don't indicate the fees of a specific ETF, which may be higher. The actual fees are detailed in the documentation for the ETF you're considering.

The ETF fees are not the only ones. The account it's held in can also add to the costs. For a standard securities account, the AMF (French Financial Markets Authority) cites:

• an account maintenance fee, which may be charged annually; ;
• brokerage fees, the AMF page concerning orders placed on shares; ;
• custody fees, which may be charged for the safekeeping of securities.

No amounts are listed here for these three lines. They vary depending on the establishment and should be requested from the establishment.

The risks of an ETF

The Key Investor Information Document (KIID) classifies the ETF's risk level on a scale of 1 to 7. The AMF lists the risks to be aware of:

• Market risk. The main risk is the fluctuation of the tracked index. If the index falls, the portfolio falls proportionally. The investor may lose all or part of their invested capital.
• Leverage effect. The AMF classifies leveraged ETFs as highly speculative investments.
• Exchange rate risk. For an ETF listed in a foreign currency, exchange rate risk must be taken into account: the variation of the currency is added to that of the index.
• Tracking gap. The performance of the ETF may deviate from that of its index.
• Liquidity risk. An ETF that tracks illiquid assets may have difficulty buying or selling its securities and incur significant transaction costs, even if it is continuously traded. Its value may then deviate from the theoretical value of the index.

In which investment vehicle should I hold an ETF?

Ordinary securities account. The AMF indicates that it may contain ETFs.

PEA. Only certain ETFs are accepted in a French equity savings plan (PEA), subject to a requirement regarding their allocation to European equities. This page does not specify this requirement; it must be verified with the official source for each ETF, the institution, and in the fund's documentation.

Numerical example (fictitious profile)

Situation. Marc, 52, a manager based in Lyon, invests €100,000 in a listed asset. For comparison purposes, we assume that the capital remains constant for 10 years and that no return is assumed.

Issue. What is the difference, in euros, between the annual fees of an ETF and those of an actively managed fund?

Strategy. Apply the AMF's orders of magnitude as assumptions: 0.5 % per year for the ETF (the AMF speaks of fees "often lower" at this level: a given ETF may be above), 1 % and 1.5 % per year for the actively managed fund (the AMF cites fees higher than 1 %, or even 1.5 % for some categories).

Result.

This profile is fictitious. The rates are assumptions based on the AMF's (French Financial Markets Authority) ranges, not ceilings or floors: the AMF states "often less than 0.5% of % per year" for ETFs and "greater than 1% of % per year" for a traditional actively managed fund. The calculation reveals nothing about the performance of an investment vehicle, nor about the account's fees. It only shows the effect of an annual fee rate on €100,000.

What changes depending on your situation

• The index tracked and the ETF's listing currency.
• The replication mode and the ETF's DIC information.
• The envelope : ordinary securities account or PEA, with different rules and taxation.
• Actual costs from the ETF and those of your institution.
• Your time horizon and your ability to withstand a capital loss.

The rule depends on your situation. No results are guaranteed.