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Long-term Investing with Stock ETFs

Roland E. Suri, Zurich, Dec 2014, download available from

Keywords: ETF, value stocks, small cap stocks, long-term investing, asset allocation, risk-return tradeoff, private investors, Vanguard, iShares, Wisdomtree, witholding tax, international investing, online broker.

  • 1. Portfolio for Long-term Investors


  • 1.1 DO’S and DON’TS


  • 1.2 Long-term



  • 1.3 Value and Style Rotation and Combination






Value-Growth Combinations



Market Timing for Value


MSCI Indices

  • 1.4 ..................................................................................................................................



Net Return Index versus Total Return Index


Small Value

  • 1.5 ....................................................................................................................................



  • 1.6 ............................................................................................................................................


  • 1.7 Recommended Non-US ETFs









Small Value




Emerging Markets Small Value


  • 2. Counterparty Risks of ETFs


  • 2.1 ........................................................................................................................................



  • 2.2 WisdomTree .................................................................................................................................


  • 2.3 iShares Europe Domicile


  • 2.4 ...........................................................................................................................

Further Reading


  • 3. Withholding Taxes (Taxation of Investments by Foreign Countries)


  • 3.1 Location of Stock Broker


Simple Case

  • 3.2 .................................................................................................................................


  • 3.3 Countries with High Withholding Taxes



  • 3.4 Withholding Taxes above my Tax Bracket


  • 3.5 Taxes on ETFs on Fund Level


  • 4. Buying Stocks and ETFs


  • 4.1 Buying ETFs: Market Price, Spread and NAV


  • 4.2 Online Banking Security




Who pays in case of online theft?



Online Banking Security


  • 4.3 Brokers




Risk of Broker Default



Broker Domiciled in a Foreign Country



International Brokers




Brokers in Switzerland



Brokers in Germany



Brokers in



Portfolio for Long-term Investors

1.1 DO’S and DON’TS

Some key points to achive a good trade-off between risk and return (see the book Stocks for the long run, by Jeremy Siegel, translated in German “Langfristig investieren”):

The index of world stock returns (capital gain plus dividends) generate over long term a real total return of about 6 % a year, long-term world government bond indices about 2.5 % a year 1

Although stocks are riskier than bonds over short term, diversified stock funds are usually less risky than government bond funds if holding periods are longer than 15 years (if risk is definded as the worst historical real 15-year return of US stock and bond markets). Long-term investors should mostly invest in stocks and bonds. Bonds should be government bonds in your local currency (see the book by Jeremy Siegel and “The four pillars of investing” by William Bernstein).

The best estimate for the future 10 year real return of a stock index is the current Shiller Price- Earning ratio (also CAPE or PE10). You can find the current Shiller PE values for many stock indices by searching Google for Images. As of December 2014, the expected real long-term returns are about 6.5 % for European and Emerging Market stock indices and only 0 % (zero percent!) for US stock indices.

Your optimal allocation between stocks and bonds depends on your time horizon, your additional sources of income, the expected returns 2 , and your stress tolerance. Imagin your stock portfolio lost 70%. If this would induce you to sell stocks, your stock allocation is too large. See here for a questionnaire to determine your stock-bond mix.

Value stock indices, and particulary small-cap value stocks indices, give a better real return over long-term than the total stock market index. Value ETFs have similar risk as the total stock market. Small-cap value stocks indices have larger risk than the total stock market for short periods but similar risk for periods of 10 years and longer.

To minimize risk, a US or Euroland investor should own about 30% foreign stocks and 70% stocks in his own currency in his stock portfolio. An investor in a country with only few stocks in his local currency should invest about 50% in foreign countries. In addition to this strategic stock allocation you should fine tune your tactical stock allocation using the Shiller Price-Earning ratio. (see also Asset Allocation over 1 and 10 Years on https://sites.google.com/site/drsuriconsulting/publications; to try out asset allocations on historical data of various asset classes get Simba’s spreadsheet from bogleheads; for asset allocation see also the book The Four Pillars of Investing” by Bernstein)

Avoid the following traps:

Don’t ever sell stocks when they lost a lot of value. In a market downturn, if all the news look awful and the papers are full of ghastly news, don’t sell stocks, but instead buy stocks if you can (look at historical real stock returns of stock indices in the book “Stocks for the long run”, by Jeremy Siegel).

Don’t try to predict the ups and downs of the stock market. Neither your banker nor your newspaper can tell you anything about future stock market prices. The funds with the best management are the endowment funds of US universities and the Norwegen State fund. They have a crew of the world’s best economists, and they don’t try to time the market. If they don’t know to predict in which direction

  • 1 I took the average of two data sets about the geometric mean of world stock returns. One, the geometric mean 1950- 2012 according Figure 1 in Credit Suisse Global Investment Returns Yearbook 2013; and two, the mean 1900 - 2009 Chart 4 Credit Suisse Global Investment Returns Sourcebook 2010.

  • 2 The best return estimate for government bonds (for save countries) is the bond yield. The best estimate of their real returns is the bond yield minus inflation.

the market moves, why do you think you know? (If you still think you know a winning strategy, run it on historical data first)

Don’t try to select the best fund management. The fund performance over recent months or years depends mostly on chance and does not tell you anything about the future performance of the fund. Managed funds have on average the same performance as index funds, minus the management fees (see the book by Bogle “On Mutual Funds”).

Don’t rely on a banker, broker or consultant to buy and sell stock, bonds or ETFs for you. Buy and sell yourself using an online broker. As Bankers make their money by selling expensive products to you, you cannot expect from bankers insights for asset allocation, estimates of investment risks 3 , or even correct information on the fund expenses (TER) that you pay. Brokers make their money with your transaction fees. Your long-term performance is of minor importance to bankers and brokers. If you prefer talking to a consultant, you should pay him or her on an hourly basis and try to make sure the consultant receives no hidden kickbacks or favors for the financial products he recommends. Never sell investments on bad news, but only because you are going to enjoy spending the money.

I would not buy a mutual fund or ETF that is managed by a traditional bank that is also involved in investment banking for its own accounts. Since such banks also deal with stocks for their own books, such banks have every incentive to sell bad stocks into the fund at an inflated price. There are many tricks to do this and some may even be legal (such as frontrunning). A bank may also use their stock analysis first for trading on its own books and only afterwards for trading by the fund.

The management fee (TER) of ETFs or mutual funds is usually rather similar to the loss of the fund versus the corresponding index. It should be below about 0.5% a year or less. The officially stated TER does not include all costs and may not always be true. (The Swiss Raiffeisen Index Fonds Pension Growth officially publishes a TER of 0.45% (Jan 2015), which appears to be grossly understated. It is actually a Fund of Funds. The TER should include also the fees of the subfunds according to FINMA regulations. The Raiffeisen bank did not answer my questions. The FINMA answered that they have no mandate for punishing anybody.)

If you buy single stocks, the largest single stock position in your portfolio should be less than 2% of the total portfolio to avoid unnecessary risks. In other words, if you invest equal amounts in each of 50 randomly-chosen stock positions, your risk is similar to buying an index ETF of the whole stock market.

Don’t buy stock ETFs of countries with large expected growth. Contrary to gut feeling, banker recommendations and newspaper articles, historical stock maket performance of such countries was clearly very poor. Rapid economic growth is usually not sustainable as it is often caused by asset price bubbles or increasing debts. Furthermore, such stocks are typically overpriced.

1.2 Long-term Performance

Studies on time series since the Great Depression show that value stocks outperform the total maket index without additional risk. Small value stocks perform even better, but they do have additional risk when holding periods are shorter than 10 years. The following paragraphs give a brief overview of the literature.

Fama and French (The Anatomy of Value and Growth Stock Returns, CRSP Working Paper 2007) get an overperformance of 4.2 % of value versus growth in the US stock market from 1926 2005. They divide the stock market in three thirds of similar market capitalization according the book values. Growth stocks

3 UBS recommended in May 2007 to Swatch Group investing in their absolute return fund, a “diversified” fund of funds. The UBS banker said that it was as save as a money market fund. However, Swatch lost half of the investment. The fund contained investments in the US housing market. (Such investments UBS coincidelly had in its own books and had to sell them quickly, as they lost a lot value. I am not aware of any Swiss laws that would forbid the investment fund buying securities that got sold by the bank.) The highest court in Switzerland decided that the contract entitled Vermögensverwaltungsvertrag” had never been a Vermögensverwaltungsvertrag, as Swatch executed the trades. Furthermore, UBS did not have to reimburse Swatch for the loss (Tagesanzeiger).

increased their stock return mostly by investments leading to increased book value. Value stocks increased their stock value return mostly because their P/B values improved. However, according to the book Stocks for the Long Run by Jeremy Siegel, selecting stocks by book value did not achieve overperformance in more recent years.

In another paper entitled “International


Fama and French calculate for 1975 1995 a value

advantage of 7.6 % a year versus growth. For similar 30 years in the US they get 4% a year für Value versus Growth.

For MSCI EAFE 1973 2014 4% per year, for EAFE value versus EAFE Core (see web site of MSCI Barra). For 1974 2007 I calculated for the MSCI EAFE a value advantage versus the core (core=value+growth) of 2.0 % a year (ValueEAFEGross.xls). MSCI divides in two halfs of the stock market capitalization. There was a dip of value versus growth caused by the subprime crises.

Kwag and Lee (J. Financial Planing, Value Investing and the Business Cycle) show superior risk adjusted returns for value investing on data ranging from 1950-2002. They found similar results for the Sharp and the Treynor (relative to market beta) ratios of risk. P/B, P/C, P/E and P/D definitions performed much better than the market in periods of economic contraction and expansion. P/B, P/C, and P/E definitions of value perform slightly better than the P/D definition, in particular during economic expansions.

According the book ‘Stocks for the Long Run’ by Jeremy Siegel, the highest dividend quintile gives 4 % better performance than the SP500 over about 50 years with similar risk relative SP500 and also similar risk in terms of standard deviation. The same is true for stocks with low price to earning ratio (the highest earning quintile). Since currently Wisdom Europe total dividend index pays 4.5% dividend, which is about the average of the highest 10%, Wisdomtree weighting of DEFA and Europe Dividend indices should provide about 3.5% more return than the index, or 2.5 % after tracking errors of the ETF.

According to ‘What works on wall street’, 2012, the decile with the highest dividend yield performs only 1 % better than the average stock market (1931-2009). Wisdomtree ETFs loose about 1% to the index. Hight dividend stocks performed well during the inflation of the 70s and in the first 9 years of new milleneum. He removed the tiniest and most erratic stocks, which may explain this performance. The return of combined value strategies as in the iShares EAFE value should be 4% per year higher than that of a comparable dividend ETF (with slightly higher risk). A combined value ETF should have about the same risk as the market.

Small Value has much higher return than the total market or large value (see studies by Fama and French). Small Value is over 1 year (or less) more risky than the total market. Conversely, for investors with a 10 year time horizon (or longer), small value has similar risk than the total stock market (see my study at https://sites.google.com/site/drsuriconsulting/publications or look at the total real return indices since the great depression).

1.3 Value and Style Rotation and Combination

Even if value and small value apparently beat the total market, is it perhaps advisable to buy such stocks

only in certain market conditions? The answer seems to be ‘No’. Apparently, value beats the marked in all

phases of the business cycle. Value performs even better if forward looking indicators suggest that market conditions should improve. This is reviewed in the following sections.

1.3.1 Spread

The difference in evaluation ratios of value and growth stocks is also called the spread. Publications disagree on the usefulness of the spread for market timing. Brush (2003) finds that the spread was only a useful predictive variable for the stock market crash of 2000-2003, but not for the decades before. Before this crash, the spread defined by price per cash flow became huge and indeed value outperformed. However, Cohen (Journal of Finance ca. 2002) comes to the conclusion that also before this crash the spread was a useful predictor of the value premium. He uses the Fama and French long-term data and defines the spread in terms of book value. The average spread in book value for some Swiss stocks can be

found in the Appendix of Grünefelder’s Thesis ‘Aktienmärkte, Zinsen und Zinsstruktur’(1998).

DJ EuroStoXX TMI indices distinguish growth, value, large, mid, and small. They can be bought via

iShares (EUR or SFR). The quaterly data on spread of several valuation ratios is available for DJ EuroStoXX TMI indices in the factsheet on their website (http://www.stoxx.com/download/indices/factsheets/djes_tmistyle_fs.pdf). See also

464.pdf and these comparison for successive dates.

According Fama and French, the value companies (in terms of book value) pay sometimes more dividend than the growth companies and sometimes less dividend. Similarly, Grünefelder finds no correlation between book value and dividends. If one assumes that all valuation ratios are uncorrelated, one can select a profitable index of value stocks by looking at the valuation ratios that were not used for defining value.

1.3.2 Value-Growth Combinations

Brush (2007) critizises that most publications define growth stocks as stocks of less value than value stocks. He calls this bad growth. Instead, he defines growth stocks as stocks with indicators for earning increases (similar to the MSCI definition). He uses a combination of price momentum, earning surprises, estimate revisions, and earning increases as such growth indicators. When growth and value stocks are selected like this and held for 6 months, 50% market cap of growth stocks and 50% market cap of value stocks both offer a 2%/yr advantage to the market (1971-2003). Since growth and value cycles evolve inverted, mixing both styles keeps the 2% advantage and reduces the risk. Bird (2007) selects stocks with such a combined approach to enhance portfolio return.

The book ‘What works on wall street’ (2012, O shaughnessy) shows for long term US data 1965-2009 that a combination of several value and growth indicators gives the best returns with smallest risk (see also www.whatworksonwallstreet.com). He uses PE, PS, PB, shareholder yield, and excludes stocks with 3 or 6 month of price returns that are less than the stock market returns. He then orders according to the 12 month return (momentum). The best returns, and sharpe ratios, he often gets with microcaps (<200 millions). He excludes stocks <25 millions from his analysis, as they are typically hard to buy. In my experience, stocks with market capitalization of about 50 million trade only a few times per week.

The order of seven best strategies is as follows:

  • 1. Combined value and growth indicators

  • 2. Combined value indicators (Value Comp 1-3)

  • 3. EBITA per Enterprise Value

  • 4. PE (price to earning ratio)

  • 5. Price per Cash flow

  • 6. Dividends

  • 7. Price per book

As stock selections based on dividends are not as successful as using combined value factors I suggest that Wisdome tree dividends fund are inferior to iShares Value funds (following MSCI’s combined value indicators).

Microcaps with many selection factors are often on top, but the study is so over-interpreted, that it is not sure that they are really better. (There are about 50 models tried out. Only by chance some of these models will perform excellent, but this overperformance will not hold for new data. This is a typical error with such data mining methods and is also called fishing in data. According to Occam’s razor, simple models are more trustful than complicated models.)

Best economic sectors in term of sharpe ratio were Utilities and Consumer Staples. According to Siegel’s book best sectors were Consumer Staples and Health Care. Oil companies and Gold were sometimes a hedge against crises.

1.3.3 Market Timing for Value Stocks

Bernstein’s book “Style Investing(published 1995) tries to suggest time points to buy value versus growth. He shows that growth becomes valuable when growth becomes sparse. Furthermore, value should be bought to protect against inflation, as investors prefer the earlier earnings to the later earnings, as the later earning become discounted due to inflation. However, this is not consistent with the value performance during the inflationary 1970s. He visually compares indicator variables with the growth versus value performance in graphs. Value should be bought when growth becomes more abundant, when the derivative of earnings growth is positive, when the yield curve after an economic downturn becomes steep, when long- term interest rates increase, and when inflation increases. Value should be sold and growth should be bought when the yield curve becomes inverted. High-dividend stocks are equally sensitive to inflation than low-dividend stocks (is not consistent with other studies). Bernstein’s indicators are difficult to predict and he doesn’t show any true evidence that the value-growth cycle is predictable. Furthermore, according Reilly, Value was more sensitive to inflation than growth for 1988 to 2003. Small did better than growth during inflation.

Oertman (Univ. St. Gallen, 1999) shows some evidence on data from 1985-1999 that the value-growth cycle can be predicted by a combination of eight financial indicators. Oertmann finds in monthly data that one should buy value when economic indicators predict that economic conditions are going to improve. Value should be bought if financial conditions are expected to improve. Value should loose versus growth when financial conditions deteriorate and risk premiums increase. This may reflect that the risk of value is pereceived to be larger than that of growth. However, his data series is short, doesn’t include the year 2000 events, and the statistical analysis is perhaps insufficient.

An NZZ article in 2012 mentioned that historically (but not actually) dividend-rich stocks have 20% cheaper PE than average stocks. My Wisdomtree PE data partially supports this claim.

1.4 MSCI Indices

MSCI changed the value definition March 2003 from using book value to a combination of dividend, cashflow, and predicted earnings (Fig below).

1.3.3 Market Timing for Value Stocks Bernstein’s book “ Style Investing ” (published 1995) tries to

Figure MSCI Definitions starting March 2003. Before this date they used only book value for distinguishing value from growth.

1.4.1 Net Return Index versus Total Return Index

Vanguard and iShares compare the performance (=price change plus dividend) of their ETFs with the Net Return Index (NR). Wisdomtree compares with the Total Return Index. Academic studies always take the total return index. For Europe is the MSCI NR about 15% of the dividend lower than the total return index (see website MSCI barra). For Emerging Markets it was only about 10% of the dividend. According to MSCI, this difference between net return and total return corresponds to the money the funds have to pay taxes to the countries in which the stocks are domiciled. Since funds are not natural persons, they cannot claim the double taxation treaties and thus cannot reclaim these taxes. This payment is not explicitly shown to the investor and can only be found by digging in the yearly report of the fund.

This tax should not be confused with an unrelated amount of about 15% of the dividend that is usually explicitly retained by the fund and explicitly shown in the tax documents provided to the investor, such that the investor can reclaim this money (see also the section on withholding tax below).

  • 1.5 Small Value

WisdomTree offers also Small, Mid, and Large Cap Div ETFs (via Swissquote). The International SmallCap Dividend Fund (DLS) contains mostly retail (6%) followed by banks (5%) and others. 35 % is in Pacific, thus 65 % in Europe. The Int. Large Cap Div Fund contains about 35% banks. 15 % is in Pacific. Small, mid, and large had P/E of 11.9, 13.2, and 11.6 (April 23, 2008). The risk of these three ETFs is similar to that of EAFE, and the return should be better for the large and much better for the small! The Mid Cap Div is probably least sensitive to inflation. Unfortunately Large Cap WisdomTree ETFs loose about 1% a year to the index (as of 2014, average of two ETFs) and the index is their own calculation.

The RAFI indices are calculated by FTSE and use book value, sales, dividends and cash flow. The ETFs from Powershares cost 0.5% a year but they loose 1% a year as does Wisdomtree. The PowerShares FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (PDN) performed better than the international small wisdomtree in the financial crisis. He has somewhat fewer Small Copanies in it than DLS (20% versus 40%, see Morningstar) and also more large companies (12% versus 1%). Unfortunately, the fundamentals of the RAFI ETFs looked usually not as cheap as those of the Wisdomtree ETFs (Oct 2014, see www.morningstar.com).

  • 1.6 Growth

I don’t recommend buying growth stocks. Growth is difficult to predict. Growth stocks historically peformed worse than value stocks. The earnings of a company are basically used for paying dividends and for new company investments. These new investments should over long term approximately equal the growth of the stock value. So, the historical average price to earning ratio is 15. Thus the expected real return is 6.6 % a year (100/15). If the dividend is 3%, the expected growth of the stock value should be 3.3%. If a growth stock has a price to earning ratio of 24, it can only pay 2% in dividents and invest 2% for growth.

Newspapers often recommend to buy stocks in country with rapid growth. This advice is wrong. Studies of historical data show that if a country has rapid GDP growth stock indices perform poorly on average. Even if one assumes that growth was predictable, the stock return is poor. This is because the stocks of countries with rapid growth are usually expensive in terms of price to earnings.

Trend following strategies are a type of bet on “growth”. They appear to work sometimes. There are several problems:

The the set of rules is not simple, such that the historical data may be overfitted. In the future, the rules may not work anymore.

Since we don’t know why a set of rules worked in the past, we don’t know what factors should lead

us to adapt these rules to new situations.

They require usually too much selling and buying of stocks, which causes too much fees. This turnover may cause a substantial loss such an ETF with respect to a trend following index.

1.7 Recommended Non-US ETFs

  • I recommend broadly diversified index funds that own stocks in large regions of the world to minimize the

risk. To select a fund I look at the long-term performance (return and risk) of the underlying index (history of several decades) and then subtract the tracking error of the fund. I estimate the tracking error by comparing the total fund performance with the total index performance over serveral years (see www.mornigstar.com or MSCI Barra). The tracking error is often similar to the TER.

  • 1.7.1 Plain (blend)

    • I mostly recommend broad index ETFs with small management fees, such as ETFs of Vanguard (VGK, or

VTRIX as a mutual fund) or iShares MSCI EAFE. They loose about 0.2% per year to the Net Return Index

  • 1.7.2 Value

iShares offers good ETFs for value stocks that follow indices by MSCI. The selection by the rules of MSCI for value stocks lead to historically better performance than selecting only by using the dividend (in studies looking of the US stock market). I looked mostly at MSCI EAFE value (EFV) and iShares MSCI Emerging markets value (EVAL). iShares value ETFs loose about 0.2-0.5% per Jahr to the Net Return Index. From historical studies, value should win about 2.5% to the plain index (according to studies of French und Fama) and should be equally or somewhat less risky than the plain index (see Excel sheet of Simca on Boogleheads website).

  • 1.7.3 Small Value

Powershares RAFI or Wisdomtree offer good ETFs for EAFE and Emerging Markets (DLS, DGS, DFE and others). ETFs of both companies loose 1% per Jahr to their index. Wisdomtree compares with Total Return Index, which is about 0.5% better than the NT index (see above the section on MSCI). RAFI may be better trusted than Wisdomtree as the RAFI index is calculated by an independent company. RAFI uses several indicators for value, which should lead to a better performance than Wisdomtree, which uses only dividends. There is PowerShares FTSE RAFI Europe Mid-Small UCITS ETF in EURO. In the recent years the fundamentals according to Morningstar used to look better for Wisdomtree than for RAFI (as of 2014).

Another method for buying a portfolio of small value companies is to buy single stocks with an equity screener. FT offers a good free screener that allows one to limit with regards to value factors, size, country and default risk. A small investor can buy much smaller stocks than an ETF or a fund, as micro stocks are hard to trade in large volumes. To allow for sufficient diversification, the maximal allocation to a single stock should be less than about 2% of the total stock portfolio.

  • 1.7.4 Emerging Markets Small Value

    • I know only the ETF by Wisdomtree (DGS). I believe it is a great fund. As it is more risky over short periods than the MSCI Emerging Markets, you should keep the money there for over 10 years.


Counterparty Risks of ETFs

Stock and bond ETFs face some remote risks caused by the companies that create these ETFs. One would naively expect that an index ETF somehow holds the stocks that are in the index. Unfortunately, this is usually not the case. Instead, these companies created some tricks to generate additional income. Since according to standard economic theory (see CAPM) this income cannot be generated without risks, the owner of the ETF risks to loose some of his investment, if these tricks should fail one day. Although I think such an event has never taken place, the IMF has explicitely warned about the risks of ETFs.

There are two types of ETFs, but neither of both types is without risks. ETFs domiciled in Europe are often synthetic, ETFs in US are usually replication. Synthetic means that the stocks underlying an index are not bought, but instead, a financial partner guarantees to pay the money corresponding to changes in the index. Physical replication means that stocks are really bought as one would naively expect. Unfortunately, the ETF providers usually generate some additional income by lending stocks to other companies.

Synthetic with Europe domicile is saver than synthetic with US domicile as they follow in Europe a rule that less than 10 % of the ETF capital can be at risk (10% UCITS limit).

In the following sections I describe some of the practices of Vanguard, iShares, and WisdomTree with respect to stock ETFs replication in European and Emerging Market indices. I am not an accountant, but Vanguard appears to be the safest ETF provider among these three.

2.1 Vanguard

Taken together, Vanguard uses full replication strategy, not synthetic, securities lending around 5% of capital and is fully collateralized. Here are some comments from Vanguard:

Our securities lending practices are fully disclosed in our funds’ annual reports,” said Linda Wolohan, a spokeswoman for Vanguard. Among those disclosures are the fact that Vanguard holds collateral from its counterparty that is worth 102% to 105% of the securities lent out and that the borrowed securities are valued on a daily basis. The collateral is also invested in a diversified portfolio of money-market instruments.

The Investment Company Act of 1940 provides restrictions on fund lending. According to these provisions, a fund may lend up to 33 1/3% of its total assets. However, Vanguard funds typically lend less than five percent of the fund?s net assets. The amount of securities on loan along with the revenue generated from securities lending is available in the shareholder?s semiannual and annual reports. For the Vanguard European Stock Index Fund, including all share classes, the total value of securities on loan was $432,508,000 as of April 30, 2011, the most recent semiannual report.

A number of policies and procedures exist to mitigate risks typically associated with securities lending process. 1. Open loans are fully collateralized with cash (102% for domestic securities and 105% for international securities). 2. Collateral levels are measured on a daily basis to ensure that those levels continue to meet or exceed collateral requirements. 3. Cash accepted as collateral is then invested in Vanguard's Market Liquidity Cash Managed Trust, a pool of high quality short term money market instruments managed by Vanguard's Fixed Income Group. 4. All loans are executed on an open basis, which allows Vanguard to recall a security on loan at any time.

The funds are permitted to invest a maximum of 20% of its assets in derivatives. In practice, this percentage tends to be much lower. Based upon data as of 3/31/2011, the last date such data was available, the international funds that you owned held the following percentage of assets in derivatives: European Stock Index Fund Admiral Shares and Vanguard MSCI Europe ETF 1.20% Total, 0.60% Futures, 0.59% Forward Foreign Currency Contracts Vanguard Pacific Stock Index Fund Investor Shares 1.80% Total, 1.21% Futures, 0.60% Forward Foreign Currency Contracts Vanguard Emerging Markets Stock Index Fund Admiral Shares 0.2% Total, 0.20% Futures Total International Stock Index Fund Admiral Shares 0.0% Total International Value Fund 9.70% Total, 3.15% Futures, 6.55% Forward Foreign Currency Contracts



Taken together, WisdomTree ETFs are not synthetic, but physical replication, securities lending is up to 30% and fully collateralized. Here are some comments from Wisdomtree:

The WisdomTree ETF's referenced in your email are long-only equity funds. Although they reserve the right to invest in derivatives they currently do not intend to make such investments. None of these funds holds forward contracts, swap transactions or any other instrument that would generally be considered a derivative. As such, these Funds are not exposed to counterparty risk from derivative transactions.

Each Fund may lend its portfolio securities to approved, credit-worthy counterparties (i.e., large banks and other financial institutions that pass the Fund's credit-review process) pursuant to written agreement. Each Fund may loan up to 1/3 of the value of its investment portfolio. All such loans are secured by collateral maintained in segregated accounts at the Funds' custodian. The collateral typically is equal to 102% - 105% or more of the value of the loan. While there is some credit exposure on these loans, it is minimized by the credit review process and the use of these segregated collateral accounts.

  • 2.3 iShares Europe Domicile

The European ETF and EM Value is not synthetic (no swap). Securities lending: Daily checks that collateral is more than sufficient.

Securities lending:

The value of the collateralwhich can be in cash or securitiesranges between 102.5% and 112% of the value of the loan and is marked-to-market daily.

Swap (=synthetic)

143 ETFs, of which 19 are swap-based (these are primarily managed from BGI's German office in Munich, new ETFs such as India and Russia ETFs)

There is potential counterparty exposure to the swap provider, albeit capped at 10% of the ETF's net asset value, under UCITS rules. UCITS rules mean that swaps have to be collateralised to within 90% of the fund's value. Our internal limit is normally 9% but has recently been reduced to 5% in light of current volatility. This is monitored on a daily basis by our control department in accordance with the requirements of the BaFin in Germany (Federal Financial Supervisory Authority).

  • 2.4 Further Reading

A ranking of all ETFs regarding this type of risk would be beneficial, but I couldn’t find it. The following article

is interesting:

Cited from there: “How do these practices compare with the US market? In general, European investors in swap-based ETFs are better protected. This is because, firstly, UCITS rules mean that swaps have to be collateralised to within 90% of the fund's value, while a recent article suggested that swaps purchased by similar US-based ETFs were uncollateralised, leaving the funds vulnerable in the case of a swap writer's default. Secondly, as we can see from the survey above, European ETF providers have been quite open about the operational details, including counterparty names, reset policy and collateral management policy, whereas such details have been difficult to come by in the US.

  • 3. Withholding Taxes (Taxation of Investments by Foreign Countries)

Investors pay the taxes to the country they live in and some taxes to the domicile of the stock or ETF they own. The following sections only deal with taxes you pay to other countries. These taxes are usually withholding taxes on dividends of stocks or ETFs. You see these withholding taxes on the yearly tax report, which your get from your broker.

  • I will try to explain the most usual cases for investing in foreign stocks (and foreign stock ETFs) in simple words. For a more competent review, see also the-international-investor.

This is a difficult issue, there are many special cases. I only know the Swiss perspective and I am not an expert. You should consult with an expert, if you find an affordable one, or check things out with a minor investment.

  • 3.1 Location of Stock Broker

The location of the stock broker company (or your bank) should usually not have an influence on the total income tax you end up paying, as the broker withholds the money according to the double taxation treaty of your tax domicile with the stock (or ETF) domicile. You have to inform the broker, and you should verify, that he treats you as a foreign resident or Steuerausländerin German.

(The following issue is somewhat confusing: If I own as a Swiss a stock of a Swiss company, the Swiss broker witholds 15% of the dividend, but I can get this money back with my tax return. A foreign broker would not retain this money. The total tax is the same, but with the foreign broker I have the money available earlier.)

The stamp duty taxes are charged on transactions. They do depend on the domicile of the broker.

  • 3.2 Simple Case

    • I am Swiss and own a stock (or ETF) of a company domiciled in the US. In the US, this is called Foreign Person US Source Income. The US would retain 30% if Switzerland did not have a double taxation treaty with the US. According to the double taxation treaty of Switzerland with US, this withholding is reduced to 15% of the dividents. Therefore, my broker pays to my account 85% of the dividends. When I pay my tax return in Switzerland, I get a tax refund (Pauschale Steueranrechnung) such that I recover the 15% of the dividends that got withhold by my broker. I still have to pay taxes on all my income, including these dividends, to Switzerland. Nevertheless, calculating everything together, I pay for US stocks exactly as much taxes as for Swiss stocks, which is probably the intention behind this scheme.

In addition to the US, Switzerland has double taxation treaties with other countries. For stocks domiciled in Ireland, Netherlands, Japan, Luxemburg, or England my taxes are usually the same as for Swiss stocks.

  • 3.3 Countries with High Withholding Taxes

The double taxation treaties of Switzerland with some other countries are not as favorable for me. For these countries, I cannot recover all withholding taxes from Switzerland. These counries are France, Germany,

Belgium. For stocks or ETFs domiciled in these counries, my broker subtracts something in the order of 30% of the dividends, and Switzerland pays me back only 15%. I could reclaim this money from these countries,

but the process is expensive and cumbersome. For investments below 30’000 it is probably not worth the



Withholding Taxes above my Tax Bracket

There is the other problem that Switzerland doesn’t pay me back the full amount that was retained by my broker. This happens when my tax rate of my income taxes in Switzerland is too low. Switzerland only pays back a maximum of 15% of the dividends if also my tax rate for my income tax is at least about 15%. If I earn much less income, such that my tax rate is only 10% for instance, Switzerand only pays back till a maximum of 10 % of the dividends of all foreign stocks (except the British, which don’t go on the DA1 form). In this calculation dividends of all foreight stocks and ETFs are added up (except the British). I get a refund from Switzerland that cannot be higher than my tax bracket multiplied with the dividends of all my foreign stock. For some miraculous reason, the British stocks are unfortunately excluded from this calculation (usually no withholding).

If one runs into this particular form of double-taxation, one should buy more stocks or ETFs that generate dividends but no withholdings (and are not British). Thanks to modern financial innovation, there happen to be quite some ETFs domiciled in Ireland (or Luxembourg) without any withholding taxes. Among these stocks are many Vanguard UCITS ETFs and iShares UCITS ETFs.

  • 3.5 Taxes on ETFs on Fund Level

You don’t see these taxes on your yearly tax statement that you get from your broker. You can only find out about these taxes if you dig into the annual report of your ETF provider. Vanguard, iShares, and other ETF providers have to pay taxes to the countries in which the stocks are domiciled. These taxes slightly reduce the performance of the ETF (without showing up in the TER or all-in fee). For ETFs domiciled in Ireland they may be slightly smaller than for other fund domiciled due to particularly-advantageous double taxation treaties of Ireland.

To take these taxes on the fund level into account, Vanguard and iShares (but not Wisdomtree) usually compare the fund performance on their web sites with that of the Net Return Index (and not with the total return index). See also the section above on MSCI.


Buying Stocks and ETFs

  • 4.1 Buying ETFs: Market Price, Spread and NAV

One may feel that one should buy an ETF close to its Net Asset Value (NAV), which is the value of the underlying stocks. However, the reported NAV is delayed and not sufficiently accurate. Vanguard uses the same NAV for its mutual funds. It uses the prices of market closure for foreign markets, which may have happened some hours ago. From Vangaurd: For an international ETF whose local markets are closed while the U.S. markets are open, this may mean that new information is incorporated into the ETF’s market price, leading to seemingly greater premiums and discounts relative to the ETF’s stated NAV (Rowley, 2013).“

To buy ETFs one should rely on a sufficiently small bid-ask spread and should not rely on the NAV (Vanguard). Vanguard recommends limit buy orders at, or even slightly above, the ask price (so called marketable limit orders) instead of market orders, as the order book may not be sufficient to execute the market order at a good price. You can’t know an ETF’s precise net asset value during the trading day, but you can expect it to be the midpoint between the bid and ask prices. My transaction cost is about half the bid-ask spread plus the brokerage fees.

Spreads are reported by Swiss exchange SFX and LSE. Also NAV is reported by LSE. For Vanguard Developed Europe (VEUR) the spread on LSE (USD) and SIX (CHF) around 0.2%. For FTSE EM (VDEM, VFEM) and LSE (USD or Pound) 0.1% and at SIX (CHF) 0.3%. Wisdomtree reports spreads of their ETFs on their web site.

I investigated about the NAV for EM ETF VFEM. VDEM is its name in USD. The base currency is USD and the value of the ETFs in other currencies probably correspond to the value of VDEM in USD.

Morningstar.com gives the NAV and the price for VFEM in USD on the LSE. The same NAV is shown on Vanguard.ch. The NAV was calculated on the close of the most recent trading day. The large premiums of the price (about 1% according to the daily chart) versus the NAV shown on Morningstar is probably caused by intraday fluctuations, as the bid/ask spread on interactivebrokers was tiny.

For ETFs traded on the US exchange, they give real-time NAVs by BATS, which is shown on Morningstar.com, if available. At the end of the last trading day the NAV of the EM Vanguards VWO according to BATS was almost the same as the NAV given by Vanguard (see Moringstar.com ) and almost the same as the price.

  • 4.2 Online Banking Security

4.2.1 Who pays in case of online theft?

The broker or bank often pays the stolen money back. It other cases, the broker did not pay back, such that the customer hat to bear the loss. Court rulings and regulations seem to indicate that the party pays who was less careful. Brokers often state that they will pay stolen money back if the customer followed their security guidelines. The security guidelines usually include among many other points an up-to-date malware scanner.

It is unclear to me, whether the bank or the customer has the burden of prove. In case of online theft, it often remains unclear, how the hacker got the relevant information, such that it becomes very difficult to decide, which party was careless. The money may be fraudulently paid from your brokerage account to your checking account and then sent to a faked account in your name, such that your broker may not feel responsible at all.

4.2.2 Online Banking Security

I am not an expert, but I did some investigations. You should definitely avoid any of the following common traps:

Do not click on links in E-Mails or on Websites that are supposed to lead to the login page of your broker. This is a very common attack called phishing.

Do not use simple or short passwords. Do not write down passwords

Use current antivirus software if you do banking. There is free antivirus software for Windows from Microsoft.

Do not use your banking computer in internet cafes or on public wireless networks

Never access your bank account from internet café’s or public wireless networks

If you install programs from the internet, get them from a trusted source, such as the site of a good computer magazine, and do some research (google the name of the software and “malware”)

Some attacks install key loggers on your computer that catch your passwords when you login. More sophisticated attacks use a man-in-the-middle, which means they when you log in with your one-time password (TAN) the screen you see and your instructions to your bank are getting manipulated. After logging in you may see a faked maintenance screen, but in fact your money is being stolen. As such man-in-the- middle attacks can only be successful on unencrypted data, they often happen in the browser. To avoid such such attacks you need an additional layer of security that is independent of your computer. The European Union Agency for Network and Information Security thus recommends to use a second form of communication to approve transactions, such text messages (SMS) on a cell phone (a smart phone needs antivirus software too). If you are a careful person, you may thus also consider some of the following safety precautions:

Request an independent layer of security from your broker in order to verify transactions. This can be a code sent to a safe phone (preferably not a smart phone) or calling your broker with a special phone password, which is not written down in your brokerage account settings.

Request a monthly or yearly withdrawal limit from your broker.

Buy a cheap computer and use it for online banking only. This is recommended by Kaspersky, a leading provider of antivirus software, on his German website.

Use an operating system that is safer than MS Windows or Android. Apple or Linux are safer than Windows or Android, but attacks have happened too. There are safer options:


The Chromebook from Google seems to be the safest

operating system (if you trust

Google). Google pays millions for hacking a brand new Chromebook in hacking competitions. Google never had to pay the full amount. The Chromebook operating system is based on Linux and there are regular automated updates of all software. The capabilities of the operating systems are limited and are very similar to those of the Chrome browser.


A similarly safe alternative is to boot (“start”) your computer from a read-only CD or read- only USB-stick with a variant of Linux, such as Knoppix. You then go immediately to your broker’s website, such that you cannot catch malware. Since the boot CD is read-only, any traces on your computer are lost once your computer is shut down. Such “live-CDs” can be downloaded for free or you may get them with a computer magazine. It needs some computer skills, though.

Your banking account is usually linked to an email address. It has happened that the email got spammed by a hacker, such that the owner of the bank account did not notice the emails from his bank. To avoid this and other attacks using your email, get a “secret” email address for your online banking. Google gives free email accounts with options for TAN’s (one-time passwords) or SMS access verification. On vacation you may access your email from a cybercafé using TAN’s.

Don’t call your bank using your computer (with skype) or a smart phone without antivirus. Never give your online password on the phone (but only answer to your security questions, date of birth, social security number and similar information).

Ensure that your wireless network at home uses a new password, which has to be long and with special characters. Since most wireless networks carelessly broadcast their name, the password has to be long enough to avoid brute force attacks (which try our all possible passwords).

You may suspect that your e-mail and/or computer got hacked if any of the following happens:

Your friends receive e-mails that pretend to come from you

You cannot access your account

You get pop-ups with commercials on websites that should be without such advertisement

You fully login to your account or email, but only get to see a suspicious maintenance page

In case you suspect you got hacked:

  • 1. Immediately call or write your broker (they often have a special e-mail for suspected fraud) with date and time of the incident. Don’t use the same computer or internet connection for this.

  • 2. Run a virus scan.

  • 3. Update programs including your operating system, your browser, browser plugins and add-ons, Adobe Acrobat, MS Office, Windows Media Player, and so on. (New updates are usually fixed against all known viruses)

  • 4. Change passwords

4.3 Brokers

4.3.1 Risk of Broker Default

Most people know that money in bank accounts is insured up to a certain amount according to the regulations of the country. There is a similar insurance for brokerage accounts in a case a brokerage firm stolemoney from their customers. Such insurances usually pay till a maximum amount per bank customer and till a maximum over all customers. If a county is close to bankcuptcy it can legally charge taxes in any amount on capital assets.

Brokerage companies can run out of money and default. Usually, another company will take over the customers and the customers will not note much. If the default is more chaotic, the documents about which customers own what stocks may be difficult to find, and it may take some time till the customers receive their money back. If things are even much worse, some criminals in the brokerage firm actually stole the stocks or cash and spent the money (sorry for the simplistic languare, but I believe it is correct in its essence). In this case, the customers can get only their investments back if the broker was insured. Different countries have different regulations about such insurances:

US: It will usually be insured by SIPC. In this case, the investor is insured up to a portfolio (ETFs plus mutual funds at the same company) of about 500’000 USD if the total losses caused by the broker’s default are less than some billions. Vanguard has an additional insurance for larger portfolios.

Europe: The insurance depends on the country and the portfolio is usually only insured to a maximal

amount of about 30’000 Euro. Switzerland, no insurance

UK, max of 50’000, see Financial Services Register

Singapoore, max 50’000 but only if the stocks have been bought on the Singapoore exchange.

In any case, you should make sure your broker is insured by contacting the official investor protection agency of the broker’s domicile (there are fake web sites for these agencies). The investor protection agencies also give information about many illegal tricks that you should be aware of.

  • 4.3.2 Broker Domiciled in a Foreign Country

I don’t see an advantage of a broker beeing domiciled in my home country. If the broker accepts foreigners, the application for the account can be done in a couple of hours by internet.

If you choose a broker in a foreign country, you have to make sure that the broker retains the taxes for a ‘foreign resident’ (or ‘Steuerausländer’ in German), such that the broker retains the correct withholding taxes on the stock dividends and bond income in the account. The broker’s computer system has to calculate the withholdings according for the tax treaties of your country with the domicile of the stock or ETF. If everything is done correctly, the total taxes you end up paying on your dividends after paying your tax return do not depend on the domicil of your broker.

An excellent review of international stockbrokers is on the-international-investor.

If you change money from one currency to another, almost all brokers will charge you a 0.5% fee (for

amounts below 50’000). Only Interactive Brokers (see below) seems to charge much lower fees.

  • 4.3.3 International Brokers

Interactive Brokers charges about 10 Euro for a trade with 10’000 Euro and a yearly fee of 120 Euro. The yearly fee is reduced or waived for many customers. The fees for exchanging money in different currencies seem to be much less than anywhere else. All accounts can hold many currencies. Trading takes place on a wide variety of worldwide stock markets. Interactive Brokers achive very fortunate prices by buying and selling stocks automatically at the best exchange. The trading interface was developed for professional traders. It is not trivial and can only be recommended to customers with some trading experience.

The company Interactive Brokers origins from the US and has offices in many other countries. European customers are usually forced to open the account with the UK office (SIP insurance protection is unclear to me). When trading with UK brokers one often pays a stamp duty for British and Irish stocks (0.5% to 1%). Fortunately, Irish ETFs (but not Irish stocks) are excluded from stamp duties (many UCITS ETFs are domiciled in Ireland).

Saxo is an international broker similar to Interactive Brokers, but slightly more expensive. Saxo has offices in UK, Switzerland and many other countries. Fees for exchanging currency are 0.5% (for trades below


  • 4.3.4 Brokers in Switzerland

See www.justetf.com/ch and www.moneyland.ch/de/online-trading-vergleich

Postfinance is for most people the least expensive. The standard account is in CHF, USD, and EUR, no fixed fee, about 70 CHF for a European trade of 10’000 CHF. They once forgot to pay me a dividend, which I noticed half a year later.

Swissquote is similar to Postfinance but charges 0.1% per year on the portfolio value

There was a long discussion about brokerage fees, exchange fees and 3a Konto fees in Switzerland on MRmoneymustache. The contributors are not as experienced as on the-international-investor.

If you trade with a Swiss broker on the Swiss exchange you also have to pay a small stamp duty


  • 4.3.5 Brokers in Germany

The Deutsche Bank in Germany offers trading accounts to foreigners. It is cheap (no fixed fee, about 20 Euros for 10000 Euro trade) but only offers accounts in Euros.

  • 4.3.6 Brokers in US

Vanguard Brokerage charges no yearly fee and only about 10 USD for a trade with 10’000 USD. They offer

only accounts in USD and no trading on non-US exchanges. They probably do not take foreign customers. Vanguard is the only broker I now who correctly recommends to minimize trading (although they make their income partially with your trading). Their Swiss office requires minimal investments of 100’000 and the yearly fees of the mutual funds are with 0.4% much higher than for the American funds.

InteractiveBrokers.com is almost equally inexpensive, but offers access to world-wide stock exchanges (see above).

A disadvantage of a US broker is that your heirs may have to pay US taxes if you die. All owners of stocks in US companies, US Funds, or US bonds are subject to US estate tax if they die (Economic Growth and Tax Relief Reconciliation Act of 2001). This tax also applies to foreigners inheriting to foreigners! This does not apply to smaller assets: According to H.R.436 „Certain Estate Tax Relief Act of 2009“, there is no tax on assets of less than 60’000 USD.

For a Swiss inheriting to non-US person, this estate tax only applies if the world wide assets of the Swiss are above 3,5 Mio. USD (Art. III DBA „Nachlass-Erbanfallsteuer“ CH-USA).

For residents of other countries, there are similar treaties (Figure below).

There was a long discussion about brokerage fees, exchange fees and 3a Konto fees in SwitzerlandMRmoneymustache . The contributors are not as experienced as on the-international-investor . If you trade with a Swiss broker on the Swiss exchange you also have to pay a small stamp duty (‘Stempelsteuer’). 4.3.5 Brokers in Germany The Deutsche Bank in Germany offers trading accounts to foreigners. It is cheap (no fixed fee, about 20 Euros for 10000 Euro trade) but only offers accounts in Euros. 4.3.6 Brokers in US Vanguard Brokerage charges no yearly fee and only about 10 USD for a trade with 10’000 USD. They offer only accounts in USD and no trading on non-US exchanges. They probably do not take foreign customers. Vanguard is the only broker I now who correctly recommends to minimize trading (although they make their income partially with your trading). Their Swiss office requires minimal inve stments of 100’000 and the yearly fees of the mutual funds are with 0.4% much higher than for the American funds. InteractiveBrokers.com is almost equally inexpensive, but offers access to world-wide stock exchanges (see above). A disadvantage of a US broker is that your heirs may have to pay US taxes if you die. All owners of stocks in US companies, US Funds, or US bonds are subject to US estate tax if they die (Economic Growth and Tax Relief Reconciliation Act of 2001). This tax also applies to foreigners inheriting to foreigners! This does not apply to smaller assets: According to H.R.436 „Certain Estate Tax Relief Act of 2009“ , there is no tax on assets of less than 60’000 USD. For a Swiss inheriting to non-US person, this estate tax only applies if the world wide assets of the Swiss are above 3,5 Mio. USD ( Art. III DBA „Nachlass - Erbanfallsteuer“ CH -USA). For residents of other countries, there are similar treaties (Figure below). Figure. Death Tax Treaties between US and several countries. " id="pdf-obj-16-40" src="pdf-obj-16-40.jpg">

Figure. Death Tax Treaties between US and several countries.