How to pick an ETF

by , 27th April 2018

For this article, we’re assuming you already know what your financial goals are and how much risk you want to take. If you haven’t thought about your goals yet, this article on the Vanguard website is worth reading.

Risk

Once you know your goals you can decide how much risk you want to take. Put simply, if you’re investing for something that won’t happen for 20 years – perhaps retirement – you can take more risk than if you’re investing for an event in five years’ time – perhaps your child starting at a private school.

But time isn’t the only issue here. It’s also important to know your personality. You might be investing with a 30 year time horizon but if you’re the kind of person who won’t be able to cope if the value of your investments falls dramatically, then you should probably go for a low risk strategy.

The more risk you’re prepared to take, the more money you can put in riskier investments. Normally that means the stock market or equities. Even with equities, some are riskier than others. For example, investing in emerging markets is normally seen as riskier than US stocks.

The classic lower risk investment is bonds. At the time of writing, bonds are riskier than usual because valuations are much higher than historical norms. But even with that background, you’re highly unlikely to lose half your money with a bond whereas that’s definitely in the range of possible outcomes with equities.

Assets

Having thought about risk, you can now work out what assets you want to invest in. Your main options are:

  • Equities (the stock market)
  • Bonds
  • Property
  • Commodities (especially gold)

Once you’ve decided how to split your money across all four asset classes – you don’t have to invest in all of them – you’ll find a huge range of ETFs investing in these different asset classes.

So how do you select the ETFs? Well, here are the main issues to think about:

Costs

It’s best to look at an ETF’s OCF (ongoing charges figure) when you think about the costs you have to pay to the ETF provider. Some ETFs are astonishingly cheap now. One of the cheapest is the Lyxor Core Morningstar UK NT (DR) UCITS ETF charges just 0.04% a year. So if your investment is worth £1000, you’ll be paying just 40p a year and you’ll be getting exposure to 97% of the total UK stock market.

When you think about costs, annual charges aren’t the only issue to consider. You also need to look at the bid/offer spread or the difference between the buy price and sell price. If the spread is large, that’s an extra cost for you. In an ETF is small and illiquid, the bid/offer spread is likely to be larger than for bigger rival funds.

Many investors underestimate the importance of cost. You might think there wouldn’t be a huge difference between an ETF that costs 0.04% a year and one that charges 0.4% a year. But over a long period of ten or twenty years, the difference can be substantial thanks to compound interest.

That said, cost isn’t the only criterion to consider when you pick an ETF. And sometimes a more expensive ETF can be the best option once you’ve considered five other criteria.

Plain vanilla or smart beta?

‘Plain vanilla’ ETFs track indices that are based on market cap. So, for example, an ETF that tracks the FTSE 100 is a plain vanilla ETF. ETFs tracking the S&P 500 or the Eurostoxx 50 are also plain vanilla ETFs and there are many, many others.

These ETFs are called ‘plain vanilla’ because they’re simple and easy to understand, and they’re normally the cheapest ETFs. They also dominate the ETF market. On the downside though, you end up putting more money into the largest stocks if you invest in a plain vanilla ETF, and that’s why ‘smart beta’ ETFs have become increasingly popular in recent years. These ETFs enable you to invest following particular investment strategies such as value or growth.

Smart beta ETFs tend to be more expensive than plain vanilla ones, but the performance may be better and you may end up investing a bit less in the really large stocks such as Shell and HSBC.

Indices

You should also be aware of indices. If you want to invest in the UK stock market in a cheap plain vanilla index, you might think the FTSE 100 is your only option. But, in reality, there are several other indices to consider. The most obvious is the FTSE All-share which includes a wider range of UK-listed stocks. But other providers also offer UK indices such as the MSCI UK Index. Now the MSCI index is pretty similar to the Footsie, but there can be little kinks so it pays to know exactly how an index works and how your money is being invested. In our articles on different regions, you’ll see that we look at the main stock market indices in those regions. For example, this guide to ETF investing in Japan. 

Tracking difference

Tracking difference is a very helpful metric which can help you figure out whether your ETF is doing its job or not.

If the FTSE 100 rose 10% over a year while a FTSE 100 ETF rose 9%, then that ETF’s tracking difference is 1%. Tracking difference is the difference between ETF performance and index performance.

All other things being equal, it makes sense to go for an ETF with the lowest tracking difference.

Size

You should also check the size of the ETF before you invest. If an ETF doesn’t have much money under management, it may be quite illiquid; in other words, not may shares in the ETF are bought and sold each day. That means the bid offer spread may be quite large. It’s also worth asking yourself why the ETF isn’t very popular. Is it riskier than you’ve realised? (Bad) Or was it only launched recently? (Not so bad, but bear in mind if it’s competing against much bigger funds, it may remain a minnow forever, and might even pack up at some point.)

Next steps

If you’re trying to find out more about an individual ETF – its tracking difference or assets under management, then check out a website called Trackinsight.

We’d also recommend you read all the other articles in ETFstream’s ‘Guides & Education’ section.  Some of them highlight attractive ETFs for different asset classes and sectors.

Good luck!

ETF Issuers Featured in this Article