How to choose an ETF
6 key things to consider when investing in an ETF
With thousands of ETFs in existence, how do you choose the right one for you? Great, you’re taking control of your investing life, the next step…building the portfolio. ETFs are a great building block in portfolio construction for a load of reasons but when there are so many to choose from, where do you start?
Using derivatives can increase risks associated with the ETF, so be aware!
Here are 6 key things to look at when deciding on which ETF to invest in:
- 1. The provider - is the company that builds and manages the ETF. The key thing here is to check how much experience the company has in the ETF industry. Why? A recent study carried out by PMC shows that growth in the ETF market projects another $5 trillion of funds flowing into ETFs. That means it’s a big market and a lot of firms will want to take a slice of the pie, some may lack the experience to manage ETFs well.
- 2. Exposure - When aiming to target a broad index or a specific sector, the key thing to know is exactly what the ETF’s exposure is invested in. Why? The name of an ETF doesn’t always give away the underlying index it is tracking, so it is always important to dig a little deeper.
- 3. Performance - Unlike an active fund where you value performance above the benchmark, for an ETF we value tracking error. Tracking error is the difference between the ETF return and the underlying index return. The smaller the tracking error the better! Tracking error occurs for a number of reasons including trading costs and trade timing.
- 4. The structure - is important as it determines how the ETF is built and the target index is tracked plus the type of investments it will hold. Why? This will impact the total cost, projected returns and overall risk. Most ETFs are physically replicated, which means the ETF will hold all of the companies of the underlying index i.e. all companies in the S&P 500. These are popular as it makes them transparent and easy to understand. However, where some markets are harder to get exposure to, synthetic replication will be used. This uses instruments such as futures to gain exposure to the underlying index. Using derivatives can increase risks associated with the ETF, so be aware!
- 5. Liquidity - ‘Liquidity is like oxygen, you don’t notice it until it's gone’ It’s key to look at liquidity at an ETF level and at the index level. Liquidity refers to the volume or the amount of times the ETF exchanges hands in a given day. Why? Looking just at the ETF level doesn’t tell the full story, if there is one less popular S&P 500 ETF that has lower daily volumes than another but the underlying index is extremely liquid.
- 6. Costs - One reason why ETFs are so popular is because of a cost-conscious investor base that wants to pay the least amount for ownership. Why? ETF providers will state the total expense ratio (TER) on their factsheet, but that doesn’t tell the full story. The TER accounts for management fees, license fees, custodian fees and distribution fees. What it doesn’t account for are trading costs i.e. cost of rebalancing and your own broker fees. This is important if buying/selling a small amount as average brokerage fees per trade can be up to £35 in some cases.
