How to Choose an ETF?

Exchange-traded funds (ETFs) have become popular for novice and experienced investors. They offer a way to diversify a portfolio, often with lower costs and greater flexibility than traditional mutual funds. Choosing the right ETF is crucial for maximizing returns and achieving investment goals.

Creating an Investment Strategy: Goals and Duration

Before getting into the ETF selection, creating a solid investment strategy is essential. This refers to:

• Defining Investment Goals: Are you looking to grow wealth, generate income, or preserve capital? Your goals will influence the type of ETFs you should consider.
• Determining Investment Duration: Are you investing in the short, medium, or long term? The duration impacts the risk level you can tolerate and the type of assets that might be appropriate.
• Determining your Investor Profile: It is crucial to understand your risk profile and volatility tolerance. Are you willing to face losses over time and market fluctuations?

For example, if your goal is long-term growth, consider equity ETFs that track a broad market index. Bond ETFs or dividend-focused ETFs might be more suitable if you need a steady income.

Key Factors for Selecting an ETF

Understanding the Included Assets

The first step in choosing an ETF is looking at its assets. ETFs can track various asset classes, including stocks, bonds, commodities, or a mix of these. Ensure the assets align with your investment goals. For instance, if you want exposure to technology stocks, look for an ETF that tracks a tech-focused index. Depending on the Assets it could be:

• Physical ETFs: These ETFs hold the assets they aim to track. For example, an S&P 500 ETF will own the shares of the companies in the S&P 500 index.
• Synthetic ETFs: These ETFs do not hold the underlying assets directly. Instead, they use financial derivatives to replicate the index’s performance.

Each type has its own set of advantages and risks. Physical ETFs are generally considered safer due to their tangible holdings, while synthetic ETFs can offer better tracking accuracy but come with counterparty risk.

Evaluating the ETF’s Liquidity

Liquidity refers to how easily you can buy or sell an ETF without significantly affecting its price. Highly liquid ETFs have high trading volumes and narrow bid-ask spreads, making them easier to trade. Always check the average daily trading volume and the bid-ask spread of an ETF before investing.

Understanding the Underlying Index

ETFs are designed to track the performance of an underlying index. It is vital to understand what index the ETF is tracking and how it fits into your overall investment strategy. For example, some ETFs track broad market indices like the S&P 500, while others might focus on specific sectors, countries, or investment themes.

Examples of some of the most famous indexes:

• MSCI Indexes
• S&P500
• Nasdaq 100

Analyzing Market Position

Consider the ETF’s market position, including its total assets under management (AUM) and its performance history. Larger ETFs with higher AUM are typically more stable and have lower expense ratios due to economies of scale. Reviewing the historical performance can also provide insights into how well the ETF has tracked its underlying index over time.

Costs Associated with ETFs

ETFs generally have lower costs than mutual funds, but knowing the fees is crucial. Key costs to consider include:

• Expense Ratio: This annual fee is expressed as a percentage of your investment in the ETF. Lower expense ratios can significantly enhance your returns over time.
• Trading Costs: Since ETFs are bought and sold like stocks, you may incur brokerage commissions. Some platforms offer commission-free trading for specific ETFs.
• Other Fees: Consider any additional fees, such as management fees or fees for holding the ETF in a tax-advantaged account.

Examples of ETFs and their characteristics

iShares Core MSCI World UCITS ETF (SWDA)

• Type: Physical ETF
• Focus: Tracks the MSCI World Index, providing exposure to large and mid-cap companies across 23 developed markets.
• ISIN: IE00B4L5Y983
• Exchange: London Stock Exchange (LSE)
• Liquidity: High trading volume and narrow bid-ask spread.
• Expense Ratio: 0.20%
• Performance: Over the past five years, SWDA has shown a steady average annual return of approximately 10%, reflecting the overall growth in global equities.

Vanguard FTSE All-World UCITS ETF (VWRL)

• Type: Physical ETF
• Focus: Tracks the FTSE All-World Index, covering stocks from both developed and emerging markets.
• ISIN: IE00B3RBWM25
• Exchange: London Stock Exchange (LSE)
• Liquidity: High trading volume and broad market exposure.
• Expense Ratio: 0.22%
• Performance: VWRL has delivered an average annual return of around 8% over the past five years, capturing growth in both developed and emerging markets.

Xtrackers MSCI Emerging Markets UCITS ETF (XSEM)

• Type: Synthetic ETF
• Focus: Tracks the MSCI Total Return Net Emerging Markets Index, providing exposure to emerging market equities.
• ISIN: IE00BTJRMP35
• Exchange: London Stock Exchange (LSE)
• Liquidity: Moderate to high trading volume.
• Expense Ratio: 0.25%
• Performance: XSEM has had an average annual return of 7% over the past five years, reflecting emerging markets’ volatility and growth potential.

Types of Strategies with ETFs explained

Passive Indexing

• Time Horizon: Recommended for periods of more than 10 years.
• Key Features: Diversification, rebalancing, and regular income.
• Example: ETFs that follow broad and diversified baskets of assets, including ‘dividend kings or aristocrats’, designed to provide investors with a steady income stream.

Passive indexing, also known as passive management, is a strategy that aims to replicate the performance of a specific market index, such as the S&P 500, rather than trying to outperform it. This strategy often outperforms active management in the long term due to lower costs and reduced human error.

Rotational

• Approach: Tactical investing based on countries, regions, sectors, or industries.
• Key Features: Complements core portfolio with specific ETFs.
• Example: Best ETFs in India, NASDAQ ETFs, FTSE 100 ETFs.

Rotational strategies can enhance returns by capitalising on market trends and sectoral performance.

Trend Strategies

• Approach: Best executed through automation to eliminate discretionary decisions.
• Key Features: Short to medium-term positions may involve ETFs with derivatives.
• Example: Automation tools for trading signals.

Automated trend strategies reduce cognitive biases, which are systematic patterns of deviation from norm or rationality in judgment, and improve decision-making efficiency. Common cognitive biases affecting investment decisions include overconfidence, confirmation bias, and loss aversion.

Tactical Asset Allocation (Active Management)

• Approach: Active monitoring and adjustments based on market conditions.
• Key Features: Suitable for frequent trading and understanding of risks.
• Example: Leveraged products, ETF vs ETC vs ETN tied to popular or thematic indices.

Tactical asset allocation can enhance returns but requires significant expertise and time commitment.

These strategies require different tools and types of ETFs for optimal implementation. For instance, thematic or niche ETFs might not be suitable for passive portfolios as they can increase market volatility.

Related articles:

What is ETF, and how does it work?

ETF Taxation UK

FAQs about choosing an ETF