How to Choose the Right ETF: A Comprehensive Guide
I am a passive investor who is a big believer in letting money work while we focus on getting more out of our lives (both personal and work). Therefore I think the time has come to write what characteristics to keep in mind when we have to choose the right ETF, with hundreds of ETFs available, according to my criteria.
Understanding How to Choose the Right ETF for Your Goals
This will already be the first brake for some (probably new) readers. If your goal is to beat the market or not lose and never see your investment go down then I am not the right mentor. If, however, you want to leave your money to work for itself even during a storm because you trust that human ingenuity will create more and more wealth in the long run, then we can continue.
Each section will cover a key feature to help you understand how to choose the right ETF.
Different ETF Categories
There is a wide variety of ETFs available, each focusing on different asset classes and investment strategies. Let's explore some of the key categories:
a) Equity ETFs:
For investors seeking long-term growth, equity ETFs are a solid choice. They offer exposure to stocks and can be broadly categorized into large-cap, mid-cap, and small-cap ETFs.
Sector-specific ETFs: Sector-specific ETFs allow you to target specific industries like technology, healthcare, or energy. They are suitable for investors with a keen interest in certain sectors (I was for a while).
Strategy-specific ETFs: a category of exchange-traded funds that focus on specific investment strategies like small versus big cap or growth vs value.
Theme-specific ETFs: ETFs designed to provide investors with exposure to companies and assets that are related to a particular theme. (For example Artificial Intelligence or Aging Population). I don't like this category of ETFs because they are created after a trend has already exploded. I do not advise you to invest in.
b) Bond ETFs:
Bond ETFs are ideal for those looking for income and lower risk. They invest in bonds issued by governments, corporations, or municipalities. Nothing more to say except that they are excellent for lowering the volatility (and return) of the portfolio.
d) Commodity ETFs:
Commodity ETFs provide exposure to commodities like gold, oil, or agricultural products. Lately also to cryptocurrencies.
A little problem with Commodity ETFs
Apart from precious metals, other ETFs (which in this case their name become ETN) often have a serious problem. The contango effect. I won't explain it in detail. Suffice it to say that ETNs do not buy the underlying (except precious metals, but this should still be checked, when you choose them). This leads to expiry contracts which in the long run cause the price of the ETN to fall if the price of the underlying remains constant.
Excellent tools for market timing. But that's not our goal.
Choosing an Index:
From the previous choices we are left with only shares (non-thematic), bonds, and precious metals. For precious metals it is quite easy to choose as in history only gold and silver have given excellent returns, and at most you can choose an ETF that offers a basket of various precious metals.
For bonds and stocks comes the tricky part. A reference index must be chosen. What is an index? A basket of financial instruments composed of predefined but variable quantities.
Example: The S&P500 represents the largest American stocks according to their market value. Which means that the companies inside are predefined according to some criteria, but variable in weight.
My advice is choose large and famous ones. S&P500 or the Eurostoxx 600 are better than the homemade index created by the founder of the ETF. Because this allows you to easily compare it with its peers. If the index is followed by multiple ETFs then they can be compared in order to understand how to choose the right ETF. The same for bonds.
Use of profit
When considering how to choose the right ETF, it's essential to understand how the fund handles its profits, particularly in the context of stocks and dividends. ETFs typically adopt one of two strategies: Accumulating or Distributing.
1. Distributing Funds:
Distributing funds distribute profits among the shareholders every time the underlying assets generate profits, such as dividends in the case of stocks. Investors in these funds receive regular income payouts based on the dividends generated by the ETF's holdings.
2. Accumulating Funds:
Accumulating funds take a different approach. Instead of distributing profits to shareholders, they reinvest the profits back into the fund, aligning with their current investment strategy. This approach aims to facilitate wealth appreciation by increasing the fund's net asset value (NAV) over time.
Which One Is Better?
The choice between accumulating and distributing funds typically doesn't matter significantly for most investors. The decision often comes down to personal preference and specific tax considerations in different countries. Here are some key points to consider:
Income vs. Wealth Appreciation: Distributing funds focus on providing a regular income stream to investors, making them suitable for those seeking current income. In contrast, accumulating funds prioritize wealth appreciation, allowing investors to benefit from potential capital growth.
Tax Considerations: Taxation can vary from one country to another and can impact the choice between these fund types. In some countries, dividends may be taxed differently from capital gains, which could influence the decision.
Fees and Performance: Excluding tax implications, the performance of accumulating and distributing funds should be essentially the same.
if you are accumulating assets, choose the version that makes you pay less taxes. The less tax paid the better, as they often eat up 20% of your earnings if not more.
Here is a post study I did.
Consider Fund Size
When evaluating ETFs, it's essential to take into account the fund size, which tells you the total value of the assets owned by the fund. Interestingly, while a large size might not be optimal for Mutual Funds, it is particularly welcome for ETFs, and here's why:
Lower Ask/Bid Spread: Fund size plays a crucial role in determining liquidity, but it is not the only one (see next section). The more people believed in the ETF the more it grew, which means that many have it and its volume has increased.
Lower Costs: The economies of scale come into play with larger ETFs. Costs related to managing and administering the fund tend not to scale linearly with the fund size. Larger ETFs can benefit from cost efficiencies, which can translate into lower expense ratios for investors.
Better Replication: A larger ETF can potentially replicate the performance of its underlying index more accurately. This is because with more assets under management, the ETF manager has greater flexibility in acquiring the individual components of the index, which can lead to better tracking and less tracking error.
Reduced Risks: It's rare for a large and well-established ETF to go bankrupt or disappear without consequences. A substantial fund size often indicates stability and a track record of success. Larger ETFs tend to have robust structures and are backed by reputable financial institutions, reducing the risk of unexpected disruptions.
Check the first point manually going to your broker and seeing if the spread difference is lower in percentage on larger funds. Sometimes the spread can also be caused by other problems like the ones in the next point.
What is the minimum Fund size?
Typically, 100 Millions is recommended as minimum and 500 Millions to be really safe.
Liquidity and Trading Volume
Liquidity refers to the ease with which you can buy or sell shares at or near the market price. Highly liquid ETFs tend to have tighter bid-ask spreads, reducing the cost of trading.
It's recommended for most investors to choose ETFs with higher trading volumes and liquidity. They are easier to buy and sell, ensuring you get a fair price.
Consider Tracking Error instead of Expense Ratios
I wrote a post on why you shouldn't focus too much on the TER, but rather on the tracking error. In practice the fund could for some reason cost less, for example it rebalances every 3 months instead of monthly, and therefore perform worse.
Always check the return of funds. If there is no overall winning fund over time then choose the one with the lowest TER. Do all this after checking the size of the ETFs. You wouldn't want to earn 1% more after 3 years, but having always bought the ETF with the highest spread every time, trust me.
Index Replication Strategies in ETFs
To have the same returns as an index, ETFs must replicate it, but achieving perfect replication, where the ETF precisely matches the index's composition and weights, is a very difficult. This is particularly challenging because it would require the ETF to be exceedingly large.
So, how do they do it?
In 2 ways essentially:
1. Physical Replication:
Full Replication: In this approach, the ETF owns the actual stocks that make up the index. It perfectly replicates the index composition and weights, ensuring minimal deviation from the index's performance. However, this strategy becomes challenging for large indices and when the ETF's capitalization is relatively small.
Sampling: When full replication is impractical or inefficient due to a smaller fund size or a vast index, ETFs employ sampling. They own a subset of the index's stocks that still closely mirrors the index's performance while reducing trading costs and operational complexity.
2. Synthetic Replication:
In contrast to physical replication, synthetic replication involves the use of derivatives, collaterals, and swaps rather than owning the actual stocks in the index. While this approach is more efficient, some investors prefer to avoid it due to of adding an extra possibility of risk. The entity providing the returns may go bankrupt. Even though I don't think it's ever happened before, it's still an added risk
Diversify Your ETF Portfolio
Diversification is a fundamental principle of investing. Consider building a diversified portfolio of ETFs to spread risk.
Learn how different index ETFs are related. For example, it is useless to have both the S&P500 and the ACWI, as one already contains the other by 60%, basically.
If you follow this guide then you will surely choose the right ETF among those available to you.