How To Choose The Right ETF


How To Choose The Right ETF

Exchange-traded funds (ETFs) have emerged as one of the most popular investment vehicles and there are thousands to choose from. Here we explain how to select the best ETFs for your portfolio.

Published on 8 January 2018

In recent years, exchange-traded funds (ETFs) have attracted a tremendous amount of investor interest. An ETF is a marketable security that tracks an index like the S&P 500 or a particular sector like pharmaceuticals or oil and gas.

One of the key distinguishing features of an ETF is that it follows a passive fund management style. This means that the fund manager does not try to earn a better return than the index that is being tracked. Instead, the effort is to simply replicate the return that the index makes.

The ETF industry has grown rapidly in the last decade. In 2008, assets under management (AUM) of global ETFs totalled US$715 billion. Currently, ETF assets exceed US$4.3 trillion with the largest ETF provider, BlackRock, which issues the iShares family of ETFs, accounting for over US$1.6 trillion.

The other major ETF issuers are Vanguard and State Street. Although the mutual fund industry is about four times larger, ETF volumes are growing at a faster pace.

Why are investors increasingly turning to ETFs? Here are some of the reasons for this dramatic shift in investor preferences:

  • Active fund management is losing some of its appeal. A growing number of investors have come around to the view that the stock selection techniques used by fund managers do not really yield superior returns over the long term and an ETF, which tracks a specific index, can more consistently deliver higher returns.
  • The expense ratio of an ETF is much lower than that of a mutual fund. This factor is a very important point of difference, and for many investors it tilts the scales in favour of ETFs. Even a 1% increase in the expense ratio of a fund can have a large impact on long-term returns.
  • ETFs trade like stocks. You can buy and sell them on the exchange. This allows you to place a limit order with your broker. The purchase will only be made if the ETF share is available at the price that you have specified. You can even place a stop-loss order, which allows you to buy or sell when a share reaches a certain price. You don’t get these advantages with a mutual fund.

In addition to the growth in AUM registered by ETFs, their number has also risen globally at a rapid pace from only 276 in 2003 to 4,779 in 2016.

With thousands of ETFs to choose from, how can you select the funds that best meet your requirements? The following guidelines may help:

1. What does it track?

Exchange-Traded Funds, ETF

Your selection process should start with the ETF’s underlying index. This is the single most important factor that will determine your return. If the ETF that you are planning to buy tracks, say, the S&P 500, you don’t have to spend any time on analysing the fund’s investment pattern. Of course, this assumes that you are confident that the S&P 500 will continue to provide you with an adequate return.

But an ETF that tracks a less well-known index deserves to be analysed carefully. It is important to pay attention to the stocks or bonds that comprise the index.

Additionally, you need to see how the ETF is weighted. An equal-weight index will invest the same amount in each stock. Large companies and smaller firms will have the same weight. You may not agree with this investment strategy, but you could miss this point if you do not study the prospectus before you invest.

2. The expense ratio matters

One of the greatest attractions of an ETF is its low fee structure. But every fund does not have a similar expense ratio. The SPDR S&P 500, which has an AUM of US$241 billion, has an expense ratio of 0.09%. An investment of US$50,000 will cost you just US$45 in annual fees.

However, all ETFs do not have low charges. The Direxion Daily FTSE China Bull 3X ETF, which invests in financial instruments that track the FTSE China 50 Index, has an expense ratio of 0.95%. That’s ten times the expense ratio of the SPDR S&P 500.

It is important to keep in mind that while the expense ratio plays a critical role in determining your returns, it is not the only factor that you should consider. The SPDR S&P 500 ETF delivered a nearly 19% return in 2017. The Direxion Daily FTSE China Bull 3X ETF saw gains of around 100% last year. But also bear in mind that this is a specialised fund that is highly leveraged and carries a correspondingly greater risk.

3. Check the ETF’s liquidity

Is the ETF that you are planning to buy actively traded on the stock exchange? A highly liquid ETF will be easy to sell when you want to cash out. In addition to this, your selling price will not fall as you sell your shares. High trading volumes indicate that you will not have a problem when you decide to liquidate your investment.

You should also verify the bid/ask spread before you finalise your ETF purchase. If you are selling, you will get the bid price. A buyer will have to pay the ask price. The difference is known as the spread and is retained by the broker.

The following table will illustrate why these factors should play a key role in your decision-making process.

Exchange-Traded Funds, ETF

The bid/ask spread in the case of SPDR S&P 500 ETF is only US$0.02. The Direxion Daily FTSE China Bull 3X ETF’s spread is much higher at US$0.15. The trading volumes also differ significantly.

4. Tracking difference

Exchange-Traded Funds, ETF

Every ETF’s aim is to replicate the return of the index that it tracks. But there are several factors that prevent an ETF from giving the same return as the index. The first is the ETF’s expense ratio. The costs that an ETF incurs will lead to a dilution of its returns.

An ETF that has a greater AUM may have a lower expense ratio, as it will be able to spread its costs over a larger volume of assets. This will lead to returns that are closer to those provided by the index that it tracks.

An ETF also incurs transaction and rebalancing costs, as it would need to buy and sell securities to keep as close to its targeted mix of holdings. If the ETF holds stocks that are illiquid, these costs could be higher.

If the underlying index provides a return of, say, 10%, and the tracking difference is 0.5%, your ETF will yield only 9.5%. You should check this measure of the fund’s efficiency before finalising your purchase.

The bottom line

In many ways, ETFs are superior to mutual funds and are the right product for those who favour a passive investment model. Their low costs make them very attractive. But investors should carry out a thorough due diligence before they choose from the hundreds of available funds. This exercise is especially important if you are considering investing in a niche ETF that has a low AUM.