In yesterday’s „Closing Bell,“ I described why index funds (ETFs) are so popular and how they work. However, the success of ETFs also has its downsides: the number of ETFs is growing rapidly because providers can make good money from them. But not every index fund is a sensible investment.

The universe of ETFs (Exchange Traded Funds) is large and colorful. And when making a selection, you always have to make the most important decision first: which index do you want to invest in? Because as you know, ETFs usually track an index. And there are countless of them.

Stock or bond index? Most people think of stock indices like the DAX, the Euro Stoxx 50, or the Dow Jones when they think of ETFs. But there are also bond ETFs, which contain bonds. The most well-known in this category are probably the iBoxx indices, which focus on Europe. There are iBoxx indices for fixed-income government bonds or corporate bonds from Europe or the eurozone.

However, I advise against bond ETFs. The problem is that the bonds included in these indices must have a certain, uniform remaining term, which is dictated by the „pattern“ of the index. But this means that the main advantage of the investment class „bonds“ is lost: only those who hold them until the end do not suffer any price losses, provided the issuer remains solvent. This security does not exist with bond ETFs.

Stock indices: Not all ETFs are equally useful. With stock indices, the ones that cover certain countries or entire regions are initially suitable. The MSCI World, which is one of the most popular ETF investments in Germany, is very broad. But keep in mind: this index does not include all emerging markets, not even the big ones like China or Brazil. Additionally, this index is heavily US-focused, so it is not as regionally diversified as you might want as an investor.

What lessons can we learn from this? Take a close look at the index underlying an ETF. For example, the Dow Jones: this dinosaur among indices weights stocks based on prices rather than market value. There are also no clear criteria for which US companies make it into this index. This is decided by the commission responsible for the index at the Wall Street Journal.

The Standard & Poor’s 500, or S&P 500 for short, is much more transparent. Here, the weighting is strictly based on market value (market capitalization) of freely tradable stocks. And a total of 500 companies are included in this US index. Clear rules and broad diversification make this index recommendable.

The DAX is also a good index for investors. It contains 40 members, but none can have a weight of more than 10% (in March 2024, the upper limit will increase to 15%). This is also sensible because it prevents too much concentration risk. If you invest in a total of 40 companies with your ETF purchase, you probably don’t want one of them to have a weight of 20 or 30%.

My advice to you: Get to know indices better Before you buy an ETF, take a closer look at the underlying index. You should avoid concentration risks, especially. If individual stocks, sectors, or regions have too much weight, caution is required. But otherwise, with ETFs, you can easily and inexpensively cover entire markets.

For a well-diversified portfolio, ETFs are extremely cheap. And it is less important which ETF provider you choose. Whether it’s iShares, Wisdom Tree, Lyxor, Amundi, SPDR, Vanguard, or xTrackers – it doesn’t matter. You can simply choose the cheapest provider.