ETF basics: costs, replication and use of income

Basics7 min read · updated 9 September 2026 · 6 sources

Two ETFs on the same index are similar, but not identical. What matters most when choosing is the costs (TER), the type of replication, the use of income and the fund domicile, and much less whether an ETF was launched a few years earlier. More important than the choice between two good ETFs, however, is the index, i.e. which markets you buy in the first place.

What an ETF is

An ETF (exchange-traded fund) is an investment fund that is traded on a stock exchange and tracks an index. The fund's assets are segregated assets (Sondervermögen) and do not belong to the fund company. If the company goes bust, they remain with the investors. Large traders (authorised participants) can at any time exchange new fund units for the securities they contain, or vice versa. If the market price deviates from the value of the securities, this exchange becomes profitable and the deviation disappears again.

According to Ben-David et al. (2017), by the end of 2016 ETFs had reached more than 10% of the market value of stocks traded on US exchanges and accounted for over 30% of trading volume. Their main advantage over active funds is cost: French (2008) estimates that investors in the US spent 0.67% of the aggregate market value every year from 1980 to 2006 searching for better returns. A passive investor would have kept that money. More in the article Active or passive.

Costs: TER and tracking difference

The TER (total expense ratio) is the ongoing annual cost taken directly from the fund's assets. On €10,000 with a TER of 0.20%, that is €20 a year. Over a long period, the difference adds up:

What actually reaches the investor is shown by the tracking difference: the difference in return compared with the index over one year. It can be better than the TER, for example thanks to securities lending income or tax advantages, or worse because of trading costs when the index changes (see tracking error).

Frino and Gallagher (2001) studied index funds on the S&P 500: the index is a paper portfolio without costs, while the fund has to trade, reinvest dividends and follow index changes. On top of that come the spread and order fees when buying, which for savings plans with small contributions are often more than a year's TER.

Replication: physical or synthetic

Physical ETFs often lend out part of their securities against collateral and a fee. This lowers costs but brings a small additional risk. Synthetic ETFs bear the risk that the swap counterparty defaults; this is limited to 10% of the fund's assets and in practice is usually collateralised on an ongoing basis. For most investors, the type of replication matters less than the index and costs.

Accumulating or distributing?

• Accumulating: income is reinvested within the fund. Convenient for building wealth; in Germany, only the Vorabpauschale (advance lump-sum taxation) is taxed each year.
• Distributing: income is paid into your account, usually quarterly or annually. Useful if you live off the income or want to make targeted use of the saver's allowance (Sparer-Pauschbetrag).
• For returns, the difference is small. In backtests, distributions must be reinvested, otherwise the distributing fund looks worse (see CAGR, total return). More detail in the article Accumulating or distributing.

Fund domicile and size

Most ETFs traded in Germany are domiciled in Ireland or Luxembourg. Thanks to a double taxation agreement, Irish funds generally pay 15% instead of 30% withholding tax on US dividends. This is an advantage for physical ETFs with many US stocks. A fund size of a few hundred million euros reduces the risk of an ETF being closed or merged.

For advanced readers: how ETFs affect markets

Because ETFs are tied to their securities through arbitrage, they pass waves of buying and selling on to the stocks they hold. Ben-David et al. (2018) find that stocks with a high ETF ownership share are more volatile, and not because of new information about the companies. For a long-term investor this means: even broadly diversified ETFs move together in periods of stress, and market prices can temporarily deviate from the value of the securities when arbitrage stalls, for example with bond ETFs in crises.

Sharpe (1991) describes the logic of passive investing with simple arithmetic: before costs, all active investors together earn exactly the market return, because together they hold the market. After costs, the average actively managed euro must therefore lag behind the passive one. Studies of fund returns must include funds that have been liquidated. Malkiel (1995) shows how much survivorship bias otherwise flatters the results.

Checklist for choosing an ETF

1. Index first: which countries, company sizes and sectors do I want? An MSCI World contains no emerging markets, whereas a FTSE All-World does (see world portfolio).
2. Costs: compare the TER and, where available, the tracking difference over several years.
3. Size and age: a few hundred million euros in assets and several years of history reduce the risk of closure.
4. Use of income as needed: accumulating for building wealth, distributing for regular income.
5. Tradability: tight spreads on Xetra or at your own broker, and a free savings plan if you buy regularly.

How Portfolio Lab calculates it

Portfolio Lab calculates with total return prices: distributions are reinvested, and the TER is already reflected in the fund's price. You enter additional costs on top of the TER (for example for custody or advice) in the Backtest as a percentage per year; order fees, spread and savings plan fees can be specified as at a broker. Under Securities you can find ETFs by name, ISIN or WKN (the German securities code), with TER, fund size, replication, use of income and domicile; the screener filters and ranks them by return and risk. More in the backtest methodology.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.