ETF selection 101
What’s the quickest way to zero in on the best ETF for you? There are over 1,000 ETFs in the justETF database and it’s impossible to keep track of them all. But there is another way to sort the wheat from the chaff: focus on the essential information that enables you to match the right ETFs to your investment objectives. These are our top tips for doing just that…
First, pick your asset class. Do you want to invest in equities, bonds, commodities or REITS? If you’re not sure what percentage of your portfolio should be allocated to each class then try our ETF Strategy Builderto help you decide.
Next up is your diversification strategy. Do you want to spread your wealth widely across an asset class or capture unique market segments? For example, in equities, you can invest across the entire world with one ETF, or tilt towards regions such as the emerging markets, or drill down into individual countries (e.g. the UK), or even specific industries (e.g. renewable energy).
justETF tip: Diversify! Spread your money across as many different companies around the globe as you can. The simplest way to do this is with a World/All-world-ETF.
OK, it’s time to think about the index your ETF will track. A good index covers as much of the market you want to follow as possible. For example, the FTSE All-Share index tracks 98% of the investible UK stock market. That makes FTSE All-Share ETFs an excellent way of gaining exposure to UK equities.
You can google any index to find out more about it, but useful rules of thumb are:
- The more equities a market-cap index tracks, the better it represents its market.
- Broad market indices are best for diversification.
- The more an index concentrates in particular firms, industries and countries, the riskier it will be in comparison to a broader index.
For further help choosing the right index, check out our justETF Investment Guides. Each one is a quickfire guide to investing across popular asset classes, regions, countries and strategies. You also get useful tools for narrowing down your ETF choices such as index comparisons and leaderboards.
Now you have the topline questions answered, it’s time to dive deeper into the filters that help you pick out a top-notch ETF:
Selection criteria for ETFs
- Fund size
- Fund age
- Ongoing charges
- Tracking difference
- Replication method
- Income treatment (Use of profit)
- Fund domicile
- Tax status
- ISA/SIPP eligible
- ETF strategies
- ETF provider
Fund size (over £100 million)
Favour a fund size (assets under management) of more than £100 million. The ETF is liable to be profitable enough to be safe from liquidation once it grows beyond this threshold.
Rule of thumb: With a fund volume of more than £100 million, the economic efficiency is given in most cases.
Fund age (older than one year)
You can better compare ETFs once they’ve built up a reasonable track record. You need a bare minimum of one year’s performance data, three years is much better and five years is better still.
Ongoing charges (TER)
The Total Expense Ratio (TER) measures the approximate annual charge you can expect to pay for holding an ETF. It tots up the various administrative, legal, operational and marketing costs incurred by the ETF’s management and deducts those expenses from your returns. The Ongoing Charge Figure (OCF) is another term for the same thing.
The snag is that neither the TER nor the OCF are a complete account of the costs you’ll pay for an ETF. They do not include transaction costs or taxes, for example.
These hidden costs do show up in an ETF’s annual return though, so you can use performance data to more accurately compare the cost of ETFs. See tracking difference below.
The perfect ETF would deliver exactly the same return as its index. But ETF’s are subject to real-world frictions that don’t affect indices. ETFs must pay transaction charges, taxes, employee salaries, regulatory fees and a laundry list of other costs. Indices, meanwhile, are virtual world league tables so are free to compute the return of a market untroubled by ETF drag factors.
The gap between an ETF’s real-world return and an index’s virtual return is called tracking difference. A good ETF minimises tracking difference which theoretically equals the market return of the index minus the running costs of the ETF.
You can assess tracking difference by comparing ETFs that follow the same index across the same time period. Simply contrast their overall returns against each other, over the longest time period available, using justETF’s charting tools.
The returns of an ETF measure its all-important performance. Our charts and returns snapshots give you a comprehensive picture of each ETF’s performance over a variety of time periods. Remember there are quite a few pitfalls when it comes to assessing returns but our data enables you to make apples-to-apples comparisons more easily.
Liquidity refers to how efficiently you can trade an ETF on the stock exchange. The more liquid an ETF, the more likely it is you can buy and sell it swiftly for minimal cost. Broad market ETFs are usually very liquid because the underlying securities they hold are regularly traded in massive volumes. For example, the majority of shares traded on the UK stock market are highly liquid so an ETF that holds the same securities (e.g. FTSE 100 shares) can also be exchanged rapidly with a minimal markup on the price.
That markup is called the bid-offer spread and is the difference between the buy and sell price of an investment. It works the same way as buying foreign currency when you go on holiday. You always get a slightly lower price when you sell than you must pay when you buy. The spread is the middleman’s cut for offering binding buying and selling prices. These middlemen are known as market-makers and they help maintain market liquidity.
The bid-offer spread increases as liquidity declines and because it’s a cost of trading – that you pay on top of broker/platform dealing fees – it pays to choose the most liquid ETF in any given category. The key liquidity factors are:
- The underlying securities of the ETF – highly tradable is better.
- Fund size – larger tends to be better.
- Daily trading volume – more tends to be better.
- Market makers – more is better.
- Market conditions – liquidity can decline when the markets are very volatile.
How does your ETF track its index? There are three main methods:
Full physical replication where the ETF holds the same securities as the index, in the same proportions, to provide accurate performance (costs notwithstanding).
Sampling is another type of physical replication but this time the ETF holds a representative sample of the index’s securities rather than every last one. This method trades off precision index tracking against paying the huge expenses that would otherwise be incurred in following an index full of small and illiquid securities.
Synthetic replication tracks an index using a total return swap. This is a financial product that pays the ETF the exact return of the index it shadows. Swaps are commonly provided by institutions such as global investment banks in exchange for cash from the ETF provider. Synthetic replication frees an ETF from physically holding the securities of the index, which is useful when they are inaccessible, illiquid or so numerous that holding them all becomes impractical.
Synthetic replication exposes you to counterparty risk – the possibility that the swap provider could default on its obligations.
Physical replication can also expose you to counterparty risk if your ETF provider engages in security lending – the practice of loaning out securities to other financial operators for the purpose of short-selling. A provider’s security lending policy should be published on their website.
Full physical replication is obviously the most straightforward method but it’s not always available for every market.
Income treatment (Use of profit)
Distributing ETFs pay income (interest or dividends) directly into your platform/broker’s account so you can spend it or reinvest it as you see fit.
Accumulating (or capitalising) ETFs don’t pay out income but automatically reinvest it back into the product. That buys you more shares in the ETF, saves on transaction costs, and will grow the value of your investment over time.
It’s worth knowing the registered home of your ETF to avoid tax complications later. ETFs domiciled in Ireland and Luxembourg don’t levy withholding tax on UK investors which can be an issue if your product hails from other countries such as the US or France.
ETFs approved for sale in Europe are recognisable by the acronym UCITS in their name. UCITS is a set of EU regulations that sets standards for counterparty risk, asset diversification, information disclosure and other consumer protections.
US and Canadian ETFs are not governed by UCITS principles and may also be subject to further tax, legal and currency exchange disadvantages. Such ETFs are usually recognisable because UCITS is not in their name and their securities identification number (ISIN) begins with US or CA.
You’ll only find ETFs launched in Europe through justETF’s search. This is because most US products don’t have a European distribution licence and therefore cannot be advertised.
Always make sure your ETFs have reporting fund status. This enables you to avoid a nasty tax shock in the future. Offshore capital gains are liable to tax at unfavourable income tax rates instead of relatively benign capital gains tax rates unless they are reporting funds. All ETFs are domiciled outside of the UK and so count as offshore. The good news is that most UCITS ETFs are reporting funds, but it’s always worth a quick check on the factsheet. Investments in ISAs and SIPPs are immune from this problem.
ETFs are eligible investments for SIPPs and ISAs except Help To Buy ISAs. You can now hold cash and investments in a single ISA, although your account must be with an institution that can hold investments on your behalf. Investments in SIPPs and ISAs are protected from tax on interest, dividends and capital gains.
Currency risk is the chance that your overseas investments could be hit by a rising pound. For example, if the pound strengthens against the dollar then securities priced in dollars will fall in value for UK investors who measure performance in pounds. Equally, if the pound weakens against the dollar then UK investors will enjoy a returns boost on those same investments. Currency risk tends to even out over time and isn’t a major concern for most long-term investors. You can even enjoy diversification benefits from foreign currency exposure.
A little-known fact is that it’s the underlying currency of an ETF’s securities that determines your currency risk. An S&P 500 ETF exposes you to fluctuations in the pound-dollar exchange rate whether or not you choose an S&P 500 ETF with a denominated currency measured in pounds or dollars.
If you do want protection from exchange rate movements then take a look at currency-hedged ETFs.
Strategies are a way to express your views on the market using specialised ETFs. You implement a strategy by investing in ETFs focussed on key market niches. A classic example is Socially Responsible Investing (SRI). SRI ETFs weight your holdings in favour of ethical companies and away from firms that profit from industries such as alcohol, tobacco, firearms etc. Other common examples include high dividend paying ETFs and factor ETFs (or Smart Beta) that tilt towards the value, small cap, quality, low volatility or momentum strategies.
ETF’s are run by many major banks and fund companies. The mark of a good provider is how it treats its customers so look out for:
- Clear presentation of important information and policies.
- Easy accessibility of product details, documentation and data on their website.
- Key information and documents that are regularly updated.
- Information that is designed to be understood not to confuse.
ETF selection in practice
By applying these tips to the filters on our ETF screener you’ll be able to easily dial up a selection of ETFs suitable for your needs. Then you can zoom in on the fine details using our individual ETF overviews and mop up any extras on the provider’s website. Happy searching!
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