Your ETF selection checklist

If you’re thinking of investing in an ETF, here’s a checklist of issues to consider before you choose your fund:

  1. Which strategy to go for?

We’re assuming that you’ve already decided which asset you want to invest in. Let’s say you’re going for US equities.

Then you have to pick a strategy. Most ETF investors would go for a ‘plain vanilla’ passive strategy.

Plain vanilla ETFs track a market-cap weighted index such as the S&P 500 or the FTSE 100. So if your US ETF tracks the S&P 500 index, it should mimic the performance of the S&P after costs. Crucially, the individual stocks should be weighted in the index by market cap. So if McDonalds comprises 4% of the S&P’s value, then 4% of the ETF should be comprised of McDonalds shares.

Plain vanilla is nearly always the cheapest strategy – the cheapest S&P ETFs charge less than 0.05% a year. It’s also a simple strategy that has been proven to work over the long-term. (Of course, there are no guarantees that it will work in future.)

Alternatively, you could go for a ‘smart beta’ US ETF that focuses on a particular factor or strategy such as value or size or minimum volatility. These ETFs are normally more expensive than the plain vanilla passives but they diversify your portfolio.

I spoke to Oliver Smith, Portfolio Manager at IG Smart Portfolios, about factors for ETFstream’s latest Big Call Radio Show. He said that smart beta ETFs aren’t widely used by private investors and he felt that minimum volatility was the only factor really worth considering for individuals.

He likes minimum volatility ETFs because they “have proven time and time again that they do what they’re supposed to do – and that’s after a lower risk/return profile.”

The beauty of minimum volatility is that it helps to reduce risk going forward – you won’t see such big price movements on a daily or weekly basis. On the other hand, it’s far from a risk-free strategy. Minimum volatility will still trend down in a bear market, just at a less frenetic pace.

  1. Which index to go for?

Let’s say you’ve decided to go for a simple plain vanilla US strategy. Now you need to pick an index. The obvious one to go for is the S&P 500. It’s comprised of roughly 500 large-cap US stocks, and these stocks are weighted by market cap. However, it’s not your only market-cap weighted option.

You could go for the MSCI USA index which is comprised of around 620 larger US stocks. It’s not dramatically different from the S&P but it does have more stocks so you might prefer it. Or if you want to cover the vast majority of the US market, you could go for an ETF that tracks the Russell 3000 index – with around 3000 constituents it covers 98% of the US market by value.

These aren’t your only options, but the point I’m making is that even if you want to follow a simple, plain vanilla strategy, you’ll still have to think about which index you want to track. That should be at least part of your ETF selection process. Smith suggests that if you don’t know the index, check out its website.

The same issue arises if you go for a smart beta strategy. If you decide you want to invest in US value stocks, you’ll still have to choose between more than one index that offers that strategy.

  1. Cost

Cost is obviously important. If you pay too much, your investment performance will be hit.

You should definitely look at an ETF’s Total Expense Ratio (TER). It will tell you how much money you’ll pay the ETF provider (pretty much.) But don’t get too hung up on it. Especially if you’re looking at two or three ETFs that all have low charges. Oliver Smith told me ‘it doesn’t really matter if you’re looking at paying 4 basis points [0.04%] or 10 basis points.’

The TER isn’t the only cost. The bid/offer spread is also important. If there’s a big difference between the ‘buy’ and the ‘sell’ price, you will suffer – especially if you’re a frequent trader.

The bid/offer spread reflects the liquidity of the ETF and that liquidity is driven by the liquidity of the underlying asset. A US large-cap ETF should be far more liquid than a Peruvian bond ETF even if the Peruvian ETF has more money under management. Smith did add one caveat to that point though – a larger ETF will probably have more market makers trading in it, and that extra competition may push market makers to offer tighter spreads.

  1. Size

Even though liquidity isn’t driven by the size of the ETF, it’s still worth taking a look the AuM (assets under management) figure. In fact, Hoshang Daroga from Copia Capital, told me in the Big Call that size is ‘very important.’

That’s partly because it’s nice to have the reassurance that some big investors are in the ETF and think it’s worth investing in. On top of that, a larger ETF is less likely to be wound up in future. It’s a pain when an ETF is wound up. Granted, you get the value of your investment back, but you then have to reinvest the cash and you might be hit by a bill for Capital Gains Tax depending on your circumstances.

  1. Past performance

Private investors often look at past performance when they’re looking at any form of investment fund. I think that’s often a mistake. If you buy a fund that’s done well recently, there’s a good chance that it’s in a sector of the market which is now looking expensive. So don’t look at the absolute past performance figure.

However, it is worth looking at how the ETF has performed compared to the index it’s tracking. This is tracking difference.

  1. Is it UCITS?

Check that the ETF has UCITS in its name. This means that the fund is protected by UK and European regulations. There should be protections in place to protect fraud by the fund.

  1. Physical or Synthetic?

A physical ETF owns the underlying asset of the ETF. So a physical gold ETF owns actual gold that is stored in a vault somewhere. A physical FTSE 100 ETF will own shares in FTSE 100 companies.

A synthetic ETF doesn’t own the underlying asset; instead it uses derivatives such as swaps to mimic the performance of the index that’s being tracked.

The risk with synthetic ETFs is that investors can lose out if the counterparty in the swap goes bust. There are usually protections to stop investors losing out, but concern about this issue has meant that physical ETFs have become much more widespread than synthetic ones. But it’s still worth checking.


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