Choosing an ETF

If you have an interest in investing or have a portfolio the chances are you’ll be familiar with buying and selling stocks. In the case of buying and selling equities you’ll understand the bid and offer system and you’ll buy or sell the stock you want.

With an ETF you can get even more exposure or a basket of these stocks for a similar process. But, before buying an ETF it’s worth considering several factors that can help ensure the right product for the job.

An ETF can offer different exposures and different dynamics in a portfolio. Do you want to buy and hold, do you want to short stocks, hedge risk or invest in exotic foreign sectors? If so, it helps to have a clear idea of what you’re buying.

COSTS

ETFs are heralded for their low cost and most of the time, the plain vanilla stuff is exactly that – low cost.

It makes them a cost effective investment but be aware that costs are likely to rise pretty quickly if the ETF has any special feature. For example, smart beta factors or a leverage component.

By way of example, the iShares Edge S&P 500 Minimum Volatility UCITS ETF has returned 25% YTD and costs 0.20%. The iShares Core S&P 500 ETF (IUSA) has returned 21% and costs 0.07%.

It is also worth weighing up the ETF you’re buying against similar investments such as index trackers or mutual funds.

For example, the Vanguard FTSE 100 Index tracker (income) costs 0.06%p.a. Like an ETF they can be put in a tax-free ISA or SIPP. However, the Vanguard FTSE 100 ETF has an ongoing charge of 0.09%p.a.

The biggest differential here is that unlike an ETF, index trackers can’t be traded intraday, so have a good idea of what your objective is.

This cost is often called the expense ratio, but some providers have different names for it, such as ongoing charge, management fee, all in fee, etc.

Chris Mellor, head of EMEA ETF equity product management at Invesco, said: “There are a number of factors that are important when choosing an ETF, and they vary based on the type of exposure desired.

“Management fee is a major deciding factor for investors and it’s important to offer pricing in line with market standard, but investors should look at all-in performance as that’s the real return they’ll receive.”

This headline fee is important, but there will be extra costs. These come in the form of – among others – platform costs, broker fees, and trading fees.

The platforms are where ETF trading happens. Often it is done by a broker because many of the platforms don’t have direct relationships with the London Stock Exchange or their own broking capabilities. You will be paying a fee at some point.

Many platforms offer services on a percentage of assets, for example for 0-£1m invested could mean a platform fee of 0.20%.   But it can be higher or lower depending on the platform.

The trading fees are paid on ETFs and many other products, such as mutual funds. On UK platforms there is typically a fee per trade, it’s around the £10 mark on average. If you’re only investing small amounts this cost can add up, especially if you’re trading more than once a year. The cost to trade on the platforms can range from 0-£70 a trade depending on where and how you are trading.

DURATION

What’s your time horizon? If it’s buy-and-hold look at the ongoing charges and – again – consider whether the ETF is the right product for the job.

If you want to trade regularly or trade intraday. Or you want to hedge your risk short term or even day trade leverage ETPs, then ensure the ETF is right in terms of underlying and value. It also pays to know how long to hold the product in question. For example, leveraged products should really be traded by the day and not held.

INDEX TRACKING

Most ETFs track an index (as closely as possible) and therefore ultimately try to delivery the same returns of a particular index. However, tracking difference is a real thing and is the discrepancy between ETF performance and index performance.

The reality is that the ETF usually lags the index.

For example, iShares Edge MSCI Europe Multifactor UCITS ETF (IFSE) has returned 8.58% year-to-date (according to data from Bloomberg), while the MSCI Europe Diversified Multiple-Factor Index (EUR) has returned 14.68% in the same time period (according to MSCI data).  Both are in Euros.

Tracking difference is rarely nil as the above example shows.

This is because a number of factors, which prevent the ETF from perfectly mimicking its index. ETF returns don’t always lag the index the difference can be small or large, positive or negative.

Tracking difference is also not to be confused with tracking error, which is similar, but is more about variability than performance, it is measured through standard deviation.

ETF.com sums it up as “the volatility in the difference of performance between the fund and its index.”

THE INDEX

This is probably the most important feature when considering an ETF. It’s what gives you the exposure you want or need and ultimately is the key factor for your return.  The right exposure with the right factors can give you a positive return and in some cases outperformance.

MJ Lytle, CEO of Tabula Investment Management, says: “The key to any passive fund is the index that it tracks. Investment returns are driven by whether the investor is exposed to the right asset at the right time.  Currency and whether to hedge or stay long is a corollary.  If you are long the right asset but half the return comes from the currency appreciation and you hedge your currency position then you will lose 50% of the return. TER and tracking are important as to efficiency of the investment but having a low TER and tight tracking to an index that depreciates 10% does not give you a positive return.”