The War of the Portfolios: ETFs

The history of ETFs dates back to 1993, with the launch of SPY, which is based on the flagship American index, the S&P 500. It is still the best-known ETF today and has the most assets under management. These instruments are used by both large institutional investors and small investors.

The advantages of ETFs

ETFs allow you to invest easily, quickly, diversified and with minimal fees. Unlike investment funds, they are tradable on the stock market, which ensures liquidity and allows you to follow an investment strategy reliably, continuously (without delay) and without sacrificing profitability with excessively high commissions.

If ETFs are so popular with small and large investors alike, it is because they fulfill different functions depending on the size of the portfolio and the experience/know-how of the person managing it.

For beginners

For a novice, with a small capital, they allow you to enter the market in a diversified way in a single purchase, therefore with minimal costs. It is even possible, with a single ETF, to build a portfolio of different asset classes (stocks and bonds from around the world). This is the case, for example, of the GAL ETF that we mentioned in our last post.

At the level just above

For an intermediate level, with a moderate fortune, ETFs combine ideally with each other, allowing to juxtapose within a portfolio several asset classes (and even subclasses, such as sector or geographic indices). This is ideal for spreading risks over several instruments, instead of just one. The allocation possibilities are almost infinite. I present several of them in my book, and we will go through some of them in our next articles.

For the bigger fish

For a more sophisticated investor with more capital, ETFs are ideal for complementing an equity portfolio with other minority asset classes, such as gold, bonds,real estate or even bitcoin. The principle is the same as mentioned in the previous paragraph, except that part of the PF is invested directly.

Leaving minority assets to ETFs allows you to focus on stocks, saving on transaction fees and, above all, simplifying your life. Indeed, some instruments, such as bonds, real estate and gold, are more difficult to access and more time-consuming for direct investment.

ETF Defects

ETFs, however, have some limitations that stem from the very characteristics that make them attractive. Indexes are designed to reflect a portion of the market, and index ETFs therefore faithfully reproduce that image. They therefore constitute an approximate representation of the entire market.

Along the same lines, the vast majority of equity ETFs are designed to be weighted by market capitalization. This implies that, although they include small-cap stocks, their contribution to the portfolio is so small that it has a negligible impact on diversification, performance and overall risk.

For this reason, among others, ETFs have also an unfortunate tendency to look alike. Their names are different, their benchmarks are different, but ultimately their nuances are quite subtle, unless their asset classes are distinct. It's a bit like going to a supermarket like Carrefour in the dairy section. You'll find endless cartons of milk, different brands, variants, sizes and packaging. But in the end, the content is always the same. The choice can therefore be confusing.

This similarity has the consequence that ETFs, within similar asset classes, are highly correlated. In most situations, juxtaposing them in a portfolio brings nothing in terms of performance and even less in terms of risks.

Last but not least, with a few exceptions, ETFs do not care about the quality and price of their components. We will come back to this important point in detail later.

Some examples

To illustrate this, let us take the following examples:

• Invesco's QQQ tracks the Nasdaq 100 Index, which includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization. The ten largest positions constitute more than half of the index's capitalization.
• SSGA's SPY tracks the S&P 500 Index, which includes the 500 largest stock market capitalizations in the United States. The index represents 80% from US market at the capitalization level. However, Only one in seven American stocks is represented there. The ten largest positions constitute more than a third of the index's capitalization.
• Vanguard's VTI replicates the CRSP US Total Market Index, which includes almost all tradable stocks in the US (just over 3,500 positions). Microcaps and even a large portion of nanocaps are represented (only capitalizations below $15 million are missing). The ten largest positions constitute almost a third of the index's capitalization.
• VT, also from Vanguard, replicates the FTSE Global All Cap Index, which includes small, mid and large capitalization stocks from developed and emerging countries. The index has nearly 10,000 positions and represents almost 3/4 of global capitalization. However, despite this, only one in five shares worldwide is represented there. The ten largest positions make up nearly 20% of the index.

These well-known instruments are representative of what we generally see with ETFs:

• They are an approximation of the market. They generally represent it fairly well, but not perfectly, in terms of capitalization. In terms of number of stocks relative to the market, it is much more laborious. Smaller companies pay the price in large part. Only Vanguard's VTI in the examples above displays a near-perfect image of the (US) market, both in terms of capitalization and stocks.
• The capitalization weighting further accentuates this bias in favor of large companies. When we look at the ten largest positions, we see that they represent a significant part of the index and therefore of the ETF. This is obviously the case with QQQ which only has 100 positions, but it is even the case with VT which nevertheless has nearly 10,000 positions.
• Because of the capitalization weighting, the top ten positions are nearly identical, not only within these ETFs, but across a multitude of others. Even global ETFs are no exception. VT, for example, currently has only one non-US stock in the top ten positions. For the other nine positions, it is nearly equivalent to SPY.
• This similarity between ETFs is directly reflected in their correlations:

• Using multiple ETFs of similar asset classes, even at a global level, generally does not enrich a portfolio in terms of risk and return. There are a few rare exceptions to this, notably by using complementary sectoral or geographic sub-asset classes (we will see this later).
• Despite significant similarities and correlations, ETFs are paradoxically not equal, neither in terms of performance nor in terms of risks (we will return to this point later).

The problem with ETFs in the stock market

We have just seen several pitfalls of ETFs, but we have left aside the biggest one. As such, ETFs, in their vast majority, do not care about the quality or the value of their components. There are very good ones, very bad ones, cheap ones and also very expensive ones. Largely loss-making companies rub shoulders with cash cows and the stock market performances of their respective shares play a big role.

An index (and therefore an ETF) is driven up by a handful of stocks that make exceptional gains. According to S&P Dow Jones Indices, only 22 % S&P 500 stocks outperformed the index itself from 2000 to 2020. This explains why most investors (between 80 and 97% depending on the source) fail to beat the market. It is not necessarily because investors are bad, some are indeed :-), but that is not the case for all! It is mainly because the market offers them little chance. Between 2000 and 2020, while the S&P 500 gained 322 TP3T, the median stock increased by only 63 TP3T. Nearly four out of five S&P 500 stocks underperformed the index. Worse: a quarter of stocks posted downright negative performance.

S&P 500 from 12/29/2000 to 12/31/2020: distribution of the gains of its components

So, ETF or not ETF?

We have observed that ETFs offer undeniable advantages to investors, whether novice or experienced, and regardless of the size of their portfolio. However, we have also identified some important limitations. Despite the considerable variety of options available, these financial instruments generally present relatively limited diversity within the same asset classes. When it comes to stocks, it is important to highlight a clear bias towards large companies.

That said, when it comes to bonds, precious metals, commodities and real estate, exchange-traded funds offer advantages in terms of liquidity, simplicity and cost savings. For those looking to diversify their portfolio with these types of assets, using ETFs is a wise choice.

For stocks, however, the question is more nuanced. As we have highlighted, a small to medium-sized portfolio greatly benefits from using ETFs to ensure diversification at a low cost. Beyond this framework, the choice will depend more on personal preferences and the management skills of each individual.

Index management (via ETFs)

One might think that since the chances of outperforming the index are very slim, it is better to invest only in the stock market via index funds. This allows you to benefit from the performance of large winning companies that are pulling the index upwards. This approach guarantees an average annual return of around 10,% in dollars on the S&P 500 (or 7,% in real terms).

This is a proven and easy-to-adopt method, much more advantageous than letting your money sit in a bank account. However, we will see later, as well as in our next articles, that this strategy is not the most advantageous solution, both in terms of profitability and risk management.

Active management (via actions)

While it is relatively unlikely to find the big winners, it is relatively easier to find the losers, as seen in the chart above. Using a few factors of Quality, Value and Momentum, which I explain in my work and in some of my backtests, it is quite easy to separate the wheat from the chaff. Selecting stocks that meet these criteria thus allows you to obtain better results than the market.

Risk and performance

Now let's go back to our four starting ETFs and see, in addition to their correlations, how they performed.

VT

VT was very clearly outdistanced during the 17 years analyzed. Despite a very high correlation with SPY, it showed, compared to all other ETFs, a worse performance (here in USD), with a volatility yet quite high. The Sharpe ratio, which measures profitability in relation to risk, is therefore, unsurprisingly, the worst of all. This result may seem surprising, given that VT is the most diversified of these four ETFs, with nearly 10,000 positions, moreover spread throughout the world.

Yet it is this last point that largely explains VT's relative underperformance. Since the ETF includes emerging markets, it paradoxically suffers from the growth effect that characterizes stocks in these regions. This phenomenon was described by J. Siegel in his book "Stocks for the long run". The author compares emerging market stocks to growth stocks in developed countries. Both tend to underperform due to excessive investor expectations.

The IWDA ETF (London), which represents the stocks of developed countries at the global level, clearly shows this phenomenon. In blue below, it clearly outdistances VT (in pink), which is largely penalized by its emerging component (in green).

Emerging markets have been stagnating since 2010. Currently, they have become attractive again in terms of valuations, with a price/earnings ratio (PE) of 12. We can anticipate a catch-up at some point, which could have positive repercussions on VT. However, this moment could still be slow to manifest itself. Indeed, the current policy followed by some of these countries does not favor investments, thus compromising the growth of their economic and financial performances.

It should also be noted that many developed countries have also underperformed. Historically, outside the US, the best-performing stocks are in Canada, Australia and Switzerland. By looking broadly, VT therefore finds itself with a multitude of emerging countries, but also developed ones, which are underperforming. There is a cyclical part, of course. But given that this trend has continued for decades for many of these countries, there is also a significant structural part.

VT therefore does not provide any added value compared to SPY in a portfolio, whether in terms of diversification, performance or risk management. In fact, it is even the opposite.

VTI and SPY

VTI has an almost perfect correlation with SPY, even more than VT. It shows, over the analyzed period (01.07.2008 - 31.10.2024), a performance just below SPY, with a higher volatility. The Sharpe ratio is therefore also worse than its counterpart.

The phenomenon is not as marked as what we saw above with VT. This is explained by the fact that we are confined here to the US market. If VTI is more volatile than SPY, despite a higher number of positions, it is because it also includes companies with smaller capitalizations. This also explains the slightly lower performance over the period analyzed.

The chart below clearly shows the subtle difference between SPY (in blue) and VTI (in green). I also added in pink "IWM", an ETF that represents the Russell 2000 index of small caps and in orange "IWR", an ETF that represents the Russell Mid-Cap index. Both are part of the VTI "package". We can see how small and mid caps have pulled VTI down very slightly here. The effect is minimal, because their weight in the ETF is relatively modest.

However, if we go back to the beginning of VTI's launch (2001), the picture is quite different (see below). Mid Caps have performed significantly better than the others. Small companies have not done as well, but they have still performed better than in the first period analyzed. They have even performed better than the S&P 500 over the majority of the duration. Nobel Prize winners Fama and French have demonstrated that small cap stocks regularly outperform the market. We will come back to this point in detail later.

VTI can therefore be an interesting choice for investing in the American market. The differences with SPY are very subtle. Their correlation is very strong, with one or the other slightly outperforming intermittently, depending on the behavior of small and mid caps. The volume clearly favors SPY, but that of VTI is very correct, far from what is practiced in Europe (we will discuss this later).

So we have the choice between SPY and VTI. If we want to buy the entire market, having access to small and medium-sized companies in a single purchase, then we fall back on VTI. If we want to focus on large companies, we use SPY. This can be an interesting solution if we prefer to buy shares of small companies directly, which I recommend doing (we will see why later). In this case VTI is redundant.

In any case, the distinction between these two ETFs is insignificant. It is therefore preferable to choose one or the other. Buying both is not rational. If you want to diversify your investments between two different issuers, which can be wise when you have a significant portion of your capital in a single position, you can opt for SPY as well as its equivalent, VOO from Vanguard. The latter has a lower trading volume than SPY, but remains higher than that of VTI.

QQQ

QQQ is a special case. It is the least correlated to the other ETFs analyzed, which is explained by the relatively small number of positions it has (100). Above all, it displays a performance that is clearly superior to the others. In particular, its profitability is more than twice as high as VT, for barely more volatility. The Sharpe ratio is also the best of all ETFs.

QQQ’s low correlation with other ETFs, its niche market positioning, and its excellent Sharpe ratio make it a particularly attractive candidate for diversifying an investment portfolio. Let’s take a closer look.

Sub-indices and their ETFs

I mentioned at the beginning of the article that some ETFs combine ideally with each other, allowing to juxtapose within a portfolio not only several asset classes, but also sub-classes, such as sector or geographic indices. This is ideal for spreading risks over several instruments, instead of just one, which becomes necessary when wealth becomes significant. In addition, this method also often allows to obtain good results, both from a risk and performance point of view.

So, rather than focusing on a global market, we break it down into sub-indices. For example, we can combine US and Swiss stocks (SPY+EWL) or break down the US market into three sectors: technology, health and consumer goods (QQQ+XLV+VDC). The instruments chosen here are given here as examples. There are a multitude of possible configurations and we will review some of these allocations in our next posts.

It should be noted that, even if they are all based on the same asset class (stocks), some sector or geographic ETFs, such as those mentioned in the previous paragraph, are relatively poorly correlated to SPY and VT (0.8). Above all, they are even less correlated with each other (between 0.6 and 0.7):

It may seem surprising to consider QQQ as a sector ETF, since it also represents a market (the Nasdaq). However, it has a strong technological component. It is highly correlated (>0.97) to XLK and VGT, the sectoral tech ETFs of SPDR (SSGA) and Vanguard, with better profitability and a better Sharpe ratio. Furthermore, we saw above that with only 100 positions, it was less representative of the entire US market (and therefore less correlated to the latter).

With the four ETFs above, we have interesting candidates to build the equity portion of a portfolio, especially since the results in terms of risk and performance tend to be in their favor. Let's now see what happens with the other asset classes.

Other asset classes

Gold (GLD) and long-term US Treasury bonds (TLT) are essential instruments in building a portfolio because they have zero or even inverse correlation to stocks. This helps reduce the volatility of a portfolio, which is particularly useful when the market is heading south.

There are still other asset classes that we have not covered, for example real estate, commodities, corporate bonds, short and medium maturity treasury bills, etc. These can in some cases be interesting, but they are not as relevant in terms of diversification, because of a more or less high correlation with other asset classes, as shown in the following table:

Findings:

• TLT (long-term US Treasury bonds) is the ETF that displays the highest negative correlation with SPY, i.e. with the US stock market. It is a strong asset in terms of diversification, especially when the stock market falls. It is effective in reducing the volatility of the PF.
• GLD (gold) has almost zero correlation to stocks and quite low to all asset classes shown. It is also a strong asset in a portfolio, as it means that gold follows its own path, no matter what happens. No wonder it is considered a safe haven. Like TLT, it is effective in lowering PF volatility.
• VNQ (US real estate) is quite strongly correlated to the US stock market. It is therefore not an ideal candidate for diversifying a portfolio. However, we will see in our next articles that real estate can be an interesting strategy in certain cases.
• IEF (medium-maturity US Treasury bonds) is negatively correlated to SPY, but less so than TLT. In addition, it is highly correlated to the latter. It is therefore less effective than TLT in diversifying and reducing the volatility of a portfolio.
• Corporate bonds, whether high quality (LQD) or high-yield (HYG) are significantly correlated to SPY (especially HYG). They therefore do not provide anything in terms of diversification, especially since long-term profitability is quite low.
• DBC (commodities) is quite strongly correlated to SPY and has a rather disastrous long-term performance. Avoid.
• Other precious metals (not in the table), such as silver (SLV), are more correlated to the market than gold and correlated quite strongly to it, with lower profitability. Also to be avoided.

Cryptocurrencies

Cryptocurrencies, such as Bitcoin and Ethereum, are attracting increasing interest due to their very high profitability potential. Like gold, they have a low correlation with other asset classes, which can offer interesting advantages for diversifying a portfolio. However, their high volatility presents a notable challenge. Price fluctuations can be extreme, ranging from impressive gains in a very short period of time to steep declines.

Another aspect to consider is their relatively recent history, which limits the possibility of backtesting during bear market periods, such as those observed in the 2000s. This makes it difficult to assess their performance in prolonged adverse conditions. My own tests show that including cryptocurrencies in a portfolio can sometimes improve its Sharpe ratio. However, the result varies quite a bit depending on the pre-existing asset allocation.

Cryptocurrency ETFs were slow to emerge, especially in the US, because they were blocked by the SEC (Securities and Exchange Commission) until early 2024. Since then, the offer has expanded considerably. For example, there is IBIT (iShares), which is listed on the Nasdaq. It has a nice volume, with very low management fees.

Given the high volatility of cryptocurrencies, their variable effects on portfolios, and their limited historical data, I have decided not to include them in my core ETF selection, which I will use to build and test asset allocations.

Small is beautiful

Throughout this article, we have discussed the bias of ETFs in favor of large companies, either by omitting smaller ones or by heavily underweighting them because of their capitalization. We also talked about the Nobel Prize winners Fama and French who demonstrated that small-cap stocks regularly outperform the market.

So far, we have imitated the ETF industry: we have covered a large part of the asset classes and subclasses, but we have totally neglected small caps. It could not be otherwise: the offer in this area is really weak. The further down the capitalization scale we go, the fewer corresponding ETFs there are. There are plenty for Big Caps, quite a few for Mid Caps, a few for Small Caps, almost nothing for Micro Caps and nothing for Nano Caps.

You will certainly find ETFs like VTI that include the smallest companies. In itself, this is already progress. But if you want to enter this particular segment exclusively via listed funds, the path may be strewn with pitfalls.

This is a shame, because as capitalization decreases, so does the correlation with the market:

Moreover, as capitalization decreases, profitability increases:

The table above highlights two of Fama and French's factors, capitalization and value. Unfortunately, the "Value" / "Growth" distinction is missing for Micro Caps, but one can very strongly assume that the result would be consistent with the other sub-indices.

Findings:

• The smaller the companies, the more profitable they are, but also the more volatile they are.
• Despite higher volatility for smaller companies, the profitability/risk ratios (Sharpe and Sortino) are very similar to those of larger companies.
• Cheap companies relative to their fundamentals ("Value") outperform others, especially growth companies ("Growth").
• Growth works best with large caps.
• The best results in terms of profitability and Sharpe/Sortino ratios are obtained with small, valuable companies.

So the choice seems obvious. You should focus on Micro Cap Value ETFs. However, to my knowledge, there are only two ETFs dedicated to Micro Caps and they are not specifically dedicated to "Value" stocks. These are IWC (iShares) and FDM (First Trust). If we look at the higher level, we have a little more choice. We thus find ETFs linked to "Small Cap Value" type indices, such as SLYV (SPDR), VBR (Vanguard), IWN (iShares) and IJS (iShares).

However, since their launch, all of these ETFs have posted rather disappointing results, which seem to contradict the conclusions of Nobel Fama and French. Does this mean that this strategy no longer works? In truth, this anomaly is inherent to the way ETFs operate, and not to Micro Caps:

• Exchange traded funds are heavily borrowed to invest in very small companies because of the amount of money they manage. It is difficult for them to buy and sell at the right price because of the lack of liquidity of these securities. The amount of money they invest (or withdraw) directly impacts the market by several percentage points. This significantly increases their transaction costs. The management fees of Micro Cap ETFs, IWC and FDM, with a TER of 0.60%, directly reflect this phenomenon.
• The large amount under management of these ETFs has another consequence. Not only does it impact transaction costs, but it also forces index funds to cheat on the nature of the companies in which they invest. Excess money is thus diluted with companies with larger capitalizations. IWC has many small caps and even mid caps. FDM also has several small caps, some of which are very close to being mid caps. These two ETFs should rather be considered as funds of small (and medium) companies, which include micro caps. Small cap value ETFs do not do any better: they include a lot of mid caps, some of which are on the verge of being large caps. Vanguard's (VBR) even has a lot of large companies!
• This is one of the pitfalls that we have already highlighted: ETFs have a bias in favor of large caps. Since their appearance in the 1990s, the share of Micro Caps in the American stock market in terms of capitalization has been halved, whereas it was already low to begin with.
• ETFs have been directly responsible for the outperformance of large companies relative to small ones since the late 20th century. If we extend the time horizon, the picture is significantly different. The chart above, which goes back to 1972, clearly shows an advantage for small caps. If we go back even further, to 1926, they even outperformed the market by nearly two percentage points, according to J. Siegel in "Stocks for the long run".

Well before Siegel, the famous economist JM Keynes said: "In the long run, we are all dead". He is not wrong: investors do not have time to wait decades to see their stocks perform. Especially since ETFs, with their bias in favor of large caps, are not about to disappear. The good news is that it is possible to obtain excess returns with Micro Caps, even since the advent of ETFs.

The peculiarity of the smallest companies is that they include a huge number of insolvent companies. Natural selection has not had time to do its work, unlike those that have climbed the capitalization ladder. But if we add a few qualitative criteria to choose them, we obtain results that clearly lean in favor of Micro Caps. If, in addition, we add a value criterion, we even arrive at a performance that amounts to almost double the market:

By a different means, I thus arrive at the same results and the same conclusions as in my book : for Micro Caps, it is necessary to invest directly in stocks to achieve your goals. ETFs do not work in this case.

Momentum ETFs

Momentum ETFs are based on specific stock sub-indices since they focus not on a company characteristic (sector, region, market capitalization or fundamentals), but on the variation of their stock price. These ETFs are thus composed of stocks that display relatively high price dynamics. To do this, they select those whose price has performed the best over a certain period (e.g. 6 or 12 months, or even an average of the two periods). For more information, please see my book, which goes into considerable depth on the subject.

Does it work? Not really.

Large cap momentum (MTUM) and small cap momentum (XSMO) do not do better than their benchmark index (SPY, respectively IJR). Even if we add the value factor to small cap momentum (XVSM), the result remains lower than IJR. Moreover, and not surprisingly, these strategies are quite strongly correlated to the market.

The conclusion is obvious. Momentum ETFs are of no use in a portfolio. This may seem surprising because the validity of the momentum effect with stocks is supported by a very large body of academic research. I review a number of them in my book.

Momentum is a powerful catalyst for profitability, and this is even more true with quality and value small companies. If I apply momentum criteria to the quality and value Micro Caps that we tested in the penultimate table, we increase the average annual performance from 16,15% to 18,75%. These results are also perfectly in line with those I obtained in my book, with backtests that go back even further.

This means that momentum is a strategy that works, but to do so, you have to trade stocks directly. I have made several hypotheses about why momentum ETFs underperform (fees, liquidity, market impact, etc.), but none of them hold water.

I stick with this last thought: all ETFs are designed around the notion of momentum. Securities that enter an index do so because their capitalization and therefore their price has increased significantly. Conversely, they exit when the price has decreased significantly. In fact, the success of ETFs and index management is the best proof that momentum is a strategy that works. A "momentum" ETF is therefore a pleonasm. It is also funny that some investors are reluctant to invest in momentum stocks, while they do not hesitate to use ETFs.

How to choose your ETFs

We saw that there was a huge choice among ETFs and that it was easy to get lost.The good news, as we also mentioned, is that they all end up looking the same. We can even stick to a few basic ETFs. Most of the time, these are the most well-known, liquid and oldest on the market.

Liquidity

Unlike stocks, for which I often like a bit of illiquidity, for ETFs I prefer liquidity. The volume of an ETF is even the criterion that comes first in my eyes. A large volume means a minimal spread and very often rhymes with a particularly low TER. The most liquid of them display a spread so low that it is useless to use a limit order (unless you are targeting a price target). You can place a market order with your eyes closed.

Management fees (TER)

Isn't TER more important than liquidity? In theory, fund fees should be a key criterion when choosing an ETF, of course. The higher they are, the more likely it is that the fund's performance will suffer. However, most ETFs these days have TERs below 0.5%. The difference between them is so small that it has a marginal impact on results. Especially since the small advantage can quickly be lost if the spread during transactions is high. Even if you practice buy & hold, you should rebalance your portfolio at least once a year.

Let's take as an example the following four ETFs, with their TER:

• SGLD (London): 0.12%
• IAU (USA): 0.25%
• GLD (USA): 0.40%
• CSGOLD (Switzerland): 0.19%

They are all gold based and quoted in US dollars. In the chart below, despite different fees, it is virtually impossible to distinguish the four curves.

Even if we don't see it well, CSGOLD ends with a very slight lead. However, since it displays a much higher spread than the other three, it is nevertheless the least interesting of all, even for buy & hold. Conversely, GLD ends with a very slight delay, which can be explained by its slightly higher TER. But it compensates for this with a huge volume and therefore an insignificant spread.

This example illustrates well how the TER, when it is at a reasonable rate, can have a marginal impact on the performance of an ETF. It is better to focus on the trading volume, which ensures liquidity, low spreads and which in any case rhymes most of the time with a low TER. The opposite is often not true, especially outside the major financial markets.

Where to buy ETFS

The most liquid ETFs are clearly in the United States. They also display derisory fees for most of them. The choice is also enormous. We find all classes and subclasses of assets, with various management strategies, different leverage effects, etc.

However, for European investors, and to a lesser extent Swiss investors, it can be complicated to access them, especially as they can also give rise to tax issues.

European protectionism

The first obstacle to US ETFs is regulatory. For several years, the EU has been preventing products from being traded on the market if the ETF's key information document ("KIID") is not written in an approved language of the country. In the era of online translators boosted by artificial intelligence, this may raise a smile. This directive is supposed to protect investors (I love the maternal side of the EU). It is above all a big protectionist measure to promote European ETFs, most of which struggle to hold up to comparison with their American counterparts.

Unfortunately, Switzerland has largely aligned itself with this directive. Fortunately, you can still trade American ETFs there via Interactive Brokers, Charles Schwab or Saxo Bank. The other possibility is to buy European or Swiss ETFs. We will review the choices that exist in this area a little further down.

The American tax authorities

The second blockage to US ETFs could be fiscal, at least in theory. First because dividends could be taxed twice, by the USA and the country of residence. In addition, the American tax authorities could withhold, in the event of your death, 40% of the value of US assets that exceed $60,000, even if they were deposited with a financial institution outside the USA. I put all this in the conditional on purpose because it is a hypothetical risk.

Fortunately, there are double taxation treaties between the US and most other countries that avoid this kind of problem. The one for Switzerland, regulates the problem of dividends and inheritances, unless you have a fortune that goes well beyond what is necessary to be financially independent.

It depends on the situation, but we are talking about nearly ten million dollars, unless the share of US securities in your fortune is low (but in this case the tax risk is also low). I do not know the convention between France and the USA, but there is a chance that it also regulates these two points (dividends and inheritance). To be checked if necessary.

In theory, there could be administrative procedures to be carried out by your heirs with the IRS (US tax authorities), in order to benefit from the double taxation agreement and avoid the US 40% tax. Forms, in English, should be completed and provided with numerous annexes, relating to wealth. This could be relatively tedious for a person who is not comfortable with English and financial investments. However, international accounting firms (such as PWC) are equipped to do this. All you have to do is inform your descendants. This costs a few thousand francs, but it is nothing compared to the taxes that would be levied.

Again, I put all this in the conditional, because the risk that your bank or broker informs the IRS is minimal. If you ask them, most will dodge the issue by telling you that they can't tell you and that you should check with your trustee. They're covering their own backs. But according to several sources, they don't inform the IRS. This is even the case at Interactive Brokers.

As we can see, the tax risk is minimal, if not non-existent. If, despite everything, it is a blocker for you, you can always fall back on substitute ETFs with a European or Swiss domicile.

Substitute ETFs

If you can't trade US ETFs because of European protectionism or if you still have concerns about taxation, you can fall back on a substitute ETF domiciled in Europe or Switzerland. Fortunately, it's quite easy to find matches in our countries. There is less liquidity and less choice, but as I said above, we can stick to a few basics, since ETFs have an unfortunate tendency to end up looking similar.

It is necessary to differentiate between the exchange of the ETF and its domicile. Sometimes it is the same country, but often it is different. We can find ETFs domiciled in our country of residence and which are also listed there. However, the choice is most of the time meager and the volume also. This is even the case in Switzerland, the so-called country of finance.

We must therefore turn to another small country, Ireland, which has understood everything about ETFs, thanks to special tax treaties with the USA, which have allowed it to develop its financial industry to such an extent that today three quarters of European ETFs are domiciled there. There is therefore choice, in particular with BlackRock's iShares. In addition, these "Irish" ETFs are listed on the various European stock exchanges (even in Switzerland).

This last point is certainly an advantage, but it represents a new selection criterion. On which market should you buy a replacement ETF? To see things more clearly, I have created a table below that allows us to compare ETFs according to their issuer and the stock exchange on which they are listed.

The decisive criterion, as I mentioned above, is the volume. The greater the volume, the more liquidity is ensured, the lower the spread. In principle, the TER of very liquid securities is low. I added a column to ensure this, the aim being that it is less than 0.5%, but it is not a decisive criterion (see example with gold).

For ETFs that are listed on different exchanges, I systematically chose the one where the ETF is the most liquid, in order not to overload the table. The same applies when the ETF was available in an accumulation or distribution strategy.

Regarding the asset classes represented, I have selected those that will be most useful to us in building a portfolio, based on our thoughts above. We will come back to this in our next articles. I have left VT as an indication, although as we have seen, it is preferable to use SPY (or VTI) instead.

Real estate was also mentioned, which could be interesting in certain situations. However, I will not refer to it below. We will come back to it in future articles.

Notes about the table:

• There is no equivalent on the European market for VTI. Its resemblance to SPY (and therefore CSPX.L) has already been mentioned several times. So it is far from being a problem.
• Regarding Global Stocks: IWDA differs slightly from the other ETFs listed in the same row, although it displays an almost perfect correlation with VT (0.98). Indeed, as already mentioned above, it only includes developed markets, unlike its counterparts which also take into account emerging markets. This is rather a good thing, since the latter tend to underperform.

Findings:

• The volumes on US ETFs are light years away from the best European or Swiss substitutes. There is no comparison possible.
• London is clearly the best market place to trade substitute ETFs. The volumes of some other places, which are not included in the comparison, are almost scary.
• In terms of choice and volume of ETF substitutes, iShares is far ahead. Vanguard offers very few instruments, with fairly modest volumes compared to iShares. Invesco offers a bit more choice, but the volumes are quite paltry.

Very clearly, if we have the choice, we must favor American ETFs. Otherwise, we can fall back on BlackRock's iShares domiciled in Ireland.

Conclusion

Taking the time to review these ETFs was essential, as a quality assembly can only be achieved if the components are top-quality and compatible with each other. Careful evaluation ensures that each element contributes positively to the overall performance of the portfolio.