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EXCHANGE-TRADED FUNDS | MODULE 3

CHOOSING THE RIGHT ETF

Continue the ETFs course with module 3 and understand what to consider when investing in ETFs, as well as the buying and selling process.

5 KEY CONSIDERATIONS BEFORE INVESTING IN AN ETF
Before purchasing an ETF there are five factors to take into account 1) performance of the ETF 2) the underlying index of the ETF 3) the ETF’s structure 4) when and how to trade the ETF and 5) the total cost of the ETF.
Key considerations before investing in an ETF

BREAKING DOWN THE 5 CONSIDERATIONS

Consider 5 key concepts before investing in an ETF.

1) Measure performance

Performance of an ETF means more than just how much money is gained or lost as the ETF’s underlying index rises and falls. It is refers to how closely the ETF matches the index performance.

Measure how well the ETF tracks the index

The tracking error helps determine how close the ETF tracks the index returns
Tracking error
Determine how closely the ETF tracks the index returns.
The tracking difference determines the ETF’s tracking quality over time
Tracking difference
See how consistent the ETF’s tracking quality is over time.

While an ETF is closely aligned with the performance of the index it is tracking, they do not match exactly. There are several reasons, for example, the costs involved with managing an ETF can affect its performance.

2) Know the ETF’s index

With a plethora of indexes in the investing universe, how do investors pick? Financial professionals can help investors determine the appropriate index by understanding the investors’ investment objectives and the purpose of the ETF.

In order to determine the role of the ETF in a portfolio, consider the specific examples below as potential uses.

  • Access to country-specific, regional, and global assets.
  • Exposure to sectors that are areas of interest, such as technology, telecommunications, renewable energy sources or consumer goods.
  • Access to specific asset classes, which include equities, fixed income, real estate, commodities, etc.

3) Consider the ETF structure

Two types of ETF structures

Physical ETFs track the index through investing in the underlying assets
“Physical” ETF
Invests in the underlying assets of the index directly to best track the index. These are the most common types of ETFs.
Synthetic ETFs track the index through derivatives or contracts
“Synthetic” ETF
Does not invest in assets directly but tracks the index through derivatives, which are contracts where the value/price is based on the underlying asset.

ETF structures matter because they can affect the level of risk in an ETF as well as the cost of managing it. While physical ETFs are the most common, it is important to understand the structure of the ETF and pick the best one for investor’s needs.

LEARN ABOUT ETF STRUCTURES

4) Know when to trade

ETFs trade on exchange, which is why many investors use them. Like stocks, an ETF can be traded anytime during the trading hours of the exchange that the ETF is listed on. This makes ETFs more liquid than a mutual fund, which only trades once a day, at the end of the day. This liquidity and the flexibility to trade when needed is attractive to investors as it allows them to prepare for opportunities when exposure to a fund needs to be increased or decreased.

Trading tip:
Markets can be more volatile near the open and close of trading hours. Consider trading ETFs after the first and before the last 20 minutes of the trading day.*

5) Understand the costs

The two costs that occur with ETFs are transaction fees and the fund’s expense ratio. Transaction fees occur when an ETF is bought or sold, while a fund’s expense ratio is calculated annually.

HOW TO BUY AND SELL ETFs

Financial professionals can contact us directly to speak with a BlackRock specialist about the investment approach of the fund and guidance on the execution of the trade.

Individual investors can work with financial professionals to create an investment approach and discuss how to incorporate iShares ETFs into their portfolio or they can invest directly through an online brokerage account.

EXECUTING THE TRADE

When executing a trade, it is important to seek price protection, especially during times of volatility. Limit and stop-limit orders can help achieve this.

The table below explains the different types of orders that can be placed during a trade, how to determine which approach is most appropriate and the potential drawbacks of each.

Goal Order type Key feature Potential drawbacks
When price protection is prioritized over executing the trade
Buy / sell only at the determined price Limit order: order executes only at the price specified, or better Full control over worst price at which trade executes (e.g. sell as long as the price is no lower than $10 USD) Order may not execute at all (if the ETF does not reach the specified price) or may be filled only partially  
Help protect gains / reduce losses with price limits Stop-limit order: wait until price breaks through a specified level, then execute as limit order Buy or sell a security following a specified price move, with full control over worst price at which the trade can execute (e.g., sell if price dips by more than 5%, but not beyond 10%)
When executing the trade is prioritized over price protection
Buy / sell immediately   Market order: order executes as soon as possible at the best price available at the time   Immediate execution of the trade in normal market conditions   In times of market stress, the realized price may be the last quoted price. Also, the execution may be delayed (e.g., if trading is halted)  
Help protect gains / reduce losses   Stop order†: wait until price breaks through a specified level, then execute as market order   Buy or sell a security following a specified minimum price move (e.g., sell if price dips by more than 5%)

† May also be referred to as a stop-loss or stop-market order

THINK DIFFERENTLY

The five key considerations to investing in ETFs should be used as a guide and should not be used as an all-inclusive checklist. Additional considerations, such as the ETF’s provider, their size, scale, track record and commitment to the ETF industry should be assessed. All of these factors combined play a significant role in the decision-making process.

 

This concludes the third module of the ETF course. Read the next module, which dives into the differences between “physical” and “synthetic” ETF structures, to continue the course.

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Financial professional
I professionally manage portfolios on behalf of individual investors and provide financial advisory services. Examples of financial professionals include financial advisors, private bankers, etc.

Institutional investor
I professionally manage portfolios on behalf of institutions such as pension funds, sovereign funds, insurance companies, etc.

Individual investor
I buy and sell securities for my personal account, not for another company or organization. I am not a financial professional nor an institutional investor.