CHOOSING THE RIGHT ETF

Learn what to look out for when evaluating ETFs using this simple process.

There are currently more than 8,800 exchange traded products (ETPs, which includes ETFs) globally1.

 

The vast number, and accessibility of ETFs have essentially democratized investing. Whether you are a large institution, an advisor or individual, an ETF would give you the same access to the same market. Their aim is simplicity, but it’s still easy to get lost if they’re new to you. These key things to look out for when evaluating an ETF will help kickstart your journey.

ETF Performance

If you want to invest in ETFs, you’ll first need to know how to evaluate the performance of an ETF.

Performance doesn’t just mean how much money you make or lose as the ETF’s underlying index rises and falls. It is also about how closely the ETF matches the index performance.

The two ways to see how closely an ETF matches the index performance are ‘tracking error’ and ‘tracking difference'. Tracking difference addresses how closely the ETF tracks the index returns, while tracking error reflects how consistent over time the tracking quality is.

Tracking difference addresses how closely the ETF tracks the index returns.

Tracking difference

Tracking error reflects how consistent over time the tracking quality is.

Tracking error reflects how consistent over time the tracking quality is.

Both ways are equally important to determine how well the ETF tracks its index over time.

ETF Provider

Another important factor to consider when looking at performance is the provider.

In a fast-growing sector such as ETFs, there are a lot of ETF providers to choose from. Size, scale, expertise and commitment of the provider can vary significantly across the market, but are all important factors to consider as they can impact performance. Trusting that your ETF provider has the technology to keep down costs and manage risk is also vital.

Know Your Index

ETFs come in many flavors and an ETF’s performance follows an index or sector closely, like the Hang Seng or S&P500. Also, different indexes select their holdings using different rules. Therefore, choosing which index to be the underlying base of your ETF is very important.

For example, there are a few indexes that cover Japanese equities, such as MSCI Japan and TOPIX. So how do you pick?

Ask yourself “What do I want an ETF to do?” when choosing an ETF:

  1. Are you looking for access to country-specific, regional, and global assets?
  2. What sectors do you want to invest in? Perhaps its technology, telecommunications, renewable energy sources or consumer goods, for example?
  3. Or what assets will my ETF give me access to? Equities, fixed income or maybe even property or commodities.

Consider your ETF structure

In general, there are two types of ETF structures that you will come across:

  • A ‘physical’ ETF holds the underlying assets or securities of the index in the same or similar proportion as the index;
  • A ‘synthetic’ ETF seeks to replicate the index performance using derivatives.

Why should I care about an ETF’s structure? Both types of ETFs – physical and synthetic – have advantages and disadvantages and can affect the level of risk and the cost of managing an ETF. So, it’s best to know what you’re buying. Typically though, physical ETFs are the most common.

Learn more about ETF Structures.

Knowing when you can trade

You want to know how and when you can trade ETFs. 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 managed fund, which only trades once a day at the end of the day.

For investors trading large amounts of ETFs, it’s critical to further understand the multiple liquidity layers of an ETF.

Trading tip: Markets can be more volatile near the open and close. Consider trading ETFs after the first and before the last 20 minutes of the trading day2.

What does it really cost?

The great thing with ETFs is they generally cost less to invest in when compared to managed funds3

There are two costs you will incur when buying ETFs - transaction costs and annual management fees. Transaction costs are the fees you pay when buying and selling the ETF through your broker. The annual management fees combine asset management costs, bank charges, audit fees and tax that the ETF may be liable to pay on its investments. Adding these will help give you the complete total cost of ownership of ETFs to compare with other investment tools.

However, it is important to look beyond the management costs (such as Total Expense Ratio, Ongoing Charges Figure or other relevant fess relating to management fees) to determine the true total cost of an ETF.

What does it really cost

RISKS – BREAKING DOWN ETF TYPES AND ASSOCIATED RISKS

As you know, there are many different types of ETFs, and some are riskier than others

ETFs that hold securities in foreign countries

ETFs that hold securities in foreign countries

Subject to exchange rate movement

ETFs that hold securities in bonds

ETFs that hold securities in bonds

Sensitive to interest rate movements

ETFs that hold securities in emerging markets and commodities

ETFs that hold securities in emerging markets and commodities

Can be subject to more extreme market conditions

Capital at risk, the value of investment and income from it is not guaranteed

Capital at risk, the value of investment and income from it is not guaranteed

All financial investments involve an element of risk4

Points to take away

Got your investment goals in place? Don’t forget these three key things to help you choose the right ETF to help you achieve them.

  1. Performance, choice of index to track and ETF structure determine the level of return you should be looking for and what you can expect.
  2. Each ETF features distinct total costs so look beyond the immediate transaction costs - remember to look at the potential tax and risk levels.
  3. Finally select an ETF provider with size, scale, proven track record, and access to the latest technology.

ETF SELECTION AND USAGE

How to use ETFs in your portfolio

Understand why ETFs are a great addition to your portfolio and can add value to your existing investments.