A Practical Guide To Investing In Etfs From Italy

Exchange-Traded Funds (ETFs) are a great way to invest in the Italian stock market, especially if you're looking for a long-term investment strategy. ETFs are investment funds that invest in hundreds or thousands of stocks, bonds, or other types of investments, providing diversification and reducing risk. The Italian stock market has a broad market index that can be accessed at a low cost through ETFs.

When investing in ETFs in Italy, it's important to consider the fees and charges associated with different brokers and the tax implications, as Italy has a standard tax of 26% on capital gains. Additionally, it's worth noting that ETFs can be purchased through brokers or investment apps, each offering varying levels of control and management over your investments.

Some popular ETFs that focus on Italy include the iShares MSCI Italy ETF (EWI) and the Franklin FTSE Italy ETF (FLIY), which both aim to provide exposure to Italian equities and long-term capital appreciation.

Understanding the benefits of ETFs

ETFs, or Exchange-Traded Funds, are a type of investment fund that combines the best attributes of stocks and mutual funds. They offer the diversification benefits of mutual funds while mimicking the ease of stock trading.

Long-Term Growth

ETFs are best suited for long-term investment, and investing in them compounds to substantial returns over time. They are designed to be held over the long term, and data shows that this passive investing strategy gives the highest return in most cases.

Diversification

ETFs provide instant diversification by investing in hundreds or even thousands of stocks, bonds, or other types of investments. This diversification is a key benefit, as it reduces an investor's risk. With a single fund, you can gain exposure to thousands of companies in one go.

Simplicity and Low Costs

Once you've selected the right ETFs to invest in, you can sit back and watch your investments grow without having to waste time analysing individual stocks. ETFs are also a cheap way to invest due to the economies of scale and lack of active management fees. The operating expense ratios (OERs) for ETFs tend to be low, and they are often lower than those of actively managed mutual funds.

Versatility

ETFs are very versatile, allowing you to easily move money between specific asset classes such as stocks, bonds, or commodities. They trade like stocks, meaning you can buy or sell them anytime during market hours, giving you more flexibility.

Tax Efficiency

ETFs can also be more tax-efficient than mutual funds. As passively managed portfolios, they tend to realise fewer capital gains than actively managed funds. Mutual funds are required to distribute capital gains to shareholders if the manager sells securities for a profit, and this distribution is taxable.

Reinvesting Dividends

ETFs allow for the immediate reinvestment of dividends, which can boost the growth of your investment over time.

Access to Various Sectors and Markets

International ETFs, regional ETFs, and ETFs for specific industries and market niches provide access to sectors where it may be more difficult to buy and sell individual stocks and bonds.

Transparency

Most ETFs disclose their holdings on a daily basis, providing transparency into the performance of your investment.

While ETFs offer numerous benefits, it's important to remember that they are not a one-size-fits-all solution. It's crucial to evaluate them based on factors such as management costs, commission fees, how they fit into your portfolio, and their investment quality.

The differences between index funds and ETFs

Index funds and ETFs are both passively managed investment vehicles that track the performance of a specific market index, offering investors broad market exposure at a low cost. However, there are some key differences between the two:

• Trading Mechanism: Index funds can only be bought and sold at the end of the trading day, based on the fund's net asset value (NAV). In contrast, ETFs trade throughout the day on a stock exchange, like stocks, with prices fluctuating based on supply and demand.
• Minimum Investment: ETFs typically have a lower minimum investment than index funds, often requiring only the amount to buy a single share. Index funds often have higher minimums set by brokers, though these may be waived for certain types of investments or accounts.
• Taxation: ETFs are generally more tax-efficient than index funds. ETFs use an "in-kind" creation and redemption process, minimising capital gains distributions. Index funds may generate capital gains when the fund manager sells holdings, potentially triggering a tax liability for investors.
• Fees: ETFs tend to have lower expense ratios than index funds, but buying and selling them may incur trading fees. Index funds typically have no shareholder transaction costs, and while they may have management fees, these tend to be lower than those of ETFs.
• Trading Flexibility: ETFs offer more trading flexibility than index funds due to their ability to be traded throughout the day.
• Liquidity: ETFs provide greater liquidity than index funds, as they can be bought and sold at any time during the trading day.
• Diversification: Both index funds and ETFs offer instant diversification by holding a wide range of securities, though ETFs may provide exposure to all securities in their target index.

Despite these differences, both index funds and ETFs are low-cost, diversified investment options that have become popular among investors. They are suitable for long-term investors seeking broad market exposure and are generally considered safer than individual stocks due to their diversification.

How to select the right ETFs

When selecting an ETF, it is important to consider your investment goals and risk tolerance. Here are some key factors to keep in mind when choosing the right ETFs for your portfolio:

• Accumulating vs Distributing: Accumulating ETFs reinvest dividends back into the fund, while distributing ETFs pay out dividends to you. In Italy, a 26% tax is applied to capital gains, which can be paid annually or at the sale/payout of the ETF. Distributing ETFs may incur more costs due to fees and taxation.
• Asset Class: Consider the type of assets included in the ETF, such as stocks, bonds, commodities, or real estate investment trusts (REITs). Different asset classes carry varying levels of risk and reward and are taxed differently. For example, government bonds in EU states are taxed at a lower rate of 12.5%.
• Replication Strategy: Synthetically replicated ETFs are cheaper but riskier as they rely on agreements with third parties instead of actually buying shares. Physically replicated ETFs are considered more secure as they buy and hold shares in the underlying companies.
• Liquidity: ETFs offer liquidity as they trade on exchanges throughout the day. Higher trading volume indicates better liquidity and allows for easier entry and exit from positions.
• Expense Ratio: The expense ratio represents the annual fees charged by the fund. Lower expense ratios can contribute to higher overall returns.
• Underlying Index: Evaluate the underlying index tracked by the ETF and understand its composition. Consider the sectors and companies represented to assess the ETF's risk profile and potential returns.
• Investment Objectives and Risk Tolerance: ETFs offer various investment strategies, such as broad market exposure or sector-specific focus. Align the ETF with your investment goals and make sure you are comfortable with the level of risk involved.

By carefully considering these factors and doing your own research, you can make informed decisions when selecting the right ETFs for your investment portfolio.

The costs of investing with ETFs

The total cost of owning an ETF can be split into two parts: holding costs and transaction costs.

Holding Costs

Holding costs are incurred by owning an ETF. They include fees and various other factors that affect an ETF's performance. The most obvious holding cost is the ETF's annual fee, which is taken as a percentage of an investor's stake in the ETF. For example, an investor with a $10,000 stake in an ETF charging a 1% fee would pay $100 in fees per year.

Other holding costs include:

• Turnover: ETFs cycle through stocks or bonds each year, and those with a high turnover ratio may incur higher transaction costs as they buy and sell portfolio securities.
• Dividends: The dividends of stocks held in ETFs can affect the return an investor receives. ETFs organized as trusts cannot reinvest cash from dividends immediately and may miss out on returns by holding extra cash.
• Investment area: Managers of ETFs that invest in international markets must navigate a labyrinth of tax rules for the countries in which the stocks are held.
• Securities lending: ETF managers can offset some of an ETF's costs by lending out portfolio securities and making a small profit from the transactions.

Transaction Costs

Transaction costs are paid as investors buy and sell ETFs. The most obvious transaction cost is the commission, which is incurred each time an investor buys or sells an ETF. However, many brokerages and online trading platforms charge little to nothing for this.

Other transaction costs include:

• Bid-ask spread: the difference between the share price at which a market maker is willing to buy an ETF (the bid) and the price they're willing to sell it (the ask). Buyers and sellers pay to cross this spread, and costs can add up for those buying or selling ETFs frequently or in large quantities.
• Market impact: a large trade in a small ETF may move the ETF's share price against the investor.

Management Expense Ratio (MER)

The MER is the percentage of a fund's average net assets paid out of the fund each year to cover the day-to-day and fixed costs of managing the fund. This includes management fees, GST/HST, and fees paid indirectly as a result of holding other ETFs. The MER is reported in the fund's annual management report of fund performance.

Other Costs

When selecting an ETF, it's important to consider the distribution of dividends and taxation. Accumulating ETFs reinvest dividends back into the fund, so their value keeps growing. Distributing ETFs pay out dividends to the investor, who must then pay a tax for each dividend received. In Italy, a standard tax rate of 26% is applied to capital gains.

It's also worth noting that brokers charge for converting investments back into the investor's currency, so it's usually best to invest in euros.

Finally, the replication strategy should be considered. Synthetically replicated ETFs are usually cheaper because they replicate the returns of an index by making an agreement with a third party instead of buying shares. However, this introduces additional risk, as the third party may not be able to honour their swap agreement.

Example Costs of Investing with ETFs in Italy

The following costs are associated with investing in ETFs on the Italian stock market:

• Annual total expense ratio (TER): between 0.30% p.a. and 0.35% p.a.
• Standard tax rate on capital gains: 26%
• Brokerage commission for investing in a non-Euro fund: varies

The risks of investing in the FTSE MIB

The FTSE MIB index is the main Italian index, consisting of the 40 largest companies in Italy. It is the benchmark stock market index for the Borsa Italiana, the Italian national stock exchange.

As with any investment, there are risks involved when investing in the FTSE MIB. Here are some of the potential risks to consider:

• Market Risk: The value of investments in the FTSE MIB is tied to the performance of the Italian stock market. If the market experiences a downturn or a crash, the value of your investment could drop significantly.
• Concentration Risk: The FTSE MIB only includes the 40 largest companies in Italy. This concentration in a relatively small number of companies means that the index could be more volatile and susceptible to negative news or events affecting those companies.
• Country Risk: Investing in a single country index such as the FTSE MIB concentrates your exposure to that country. This means you could be more vulnerable to economic, political, or regulatory changes specifically affecting Italy. For example, the Italian referendum in 2016 caused uncertainty and impacted Italy-specific ETFs.
• Currency Risk: If you are investing in the FTSE MIB from outside Italy, you will be exposed to currency risk. Your investment returns could be affected by fluctuations in the exchange rate between your local currency and the Euro.
• Tax Risk: Italy has a capital gains tax rate of 26% on investment profits. This could impact your overall returns, especially if you choose a distributing ETF where taxes are applied to dividends.
• Counterparty Risk: Some ETFs use synthetic replication, which involves making an agreement with a third party to replicate the returns of an index. This introduces the risk that the counterparty may not be able to fulfil their obligations, potentially impacting your investment returns.

Frequently asked questions