With exchange traded funds (ETFs) likely to become a key part of retail investor portfolios, it's vital that you're able to pick those most suited to your needs. There are nine key considerations when choosing an ETF.
1. Jargon
Under ASX naming conventions, an ETF technically refers to a fund that passively tracks an index. Most exchange traded products (ETPs, the broad term the ASX uses) are ETFs. Exchange traded structured products mimic the performance of an index through derivatives or other instruments. Exchange traded managed funds are actively managed funds. Exchange traded hedge funds use complex instruments, such as short selling.
2. Issuer
Like any investment product, it pays to research the ETF issuer's record and reputation. Large issuers tend to charge lower fees and have more liquid ETFs. Smaller issuers often have niche ETFs that charge higher fees. Conservative investors who want exposure to core sharemarket indices should stick to well-known issuers.
3. Tracking difference
This is the extent to which the ETF's return deviates from the return of its benchmark index. Returns can vary according to how the issuer tracks the index, handles index rebalancing and corporate actions, and ETF fees. Issuers of well-performing ETFs minimise the tracking difference and earn their fees.
4. Costs
Because ETFs aim to provide an index return, low fees on one ETF over another can be the difference in net returns. Brokerage fees to buy and sell ETFs are another consideration. Hidden costs include the bid/ask spread, which is the difference between the highest price a bidder will pay for an ETF and the lowest price a seller will accept (the ask). A discount between the ETF's price and that of its underlying securities is another potential cost, although ETFs are designed to trade at their net asset value.
5. Liquidity
Always assess the liquidity of the ETF and the liquidity of the underlying securities it holds. Highly liquid ETFs that own highly liquid securities, such as blue-chip stocks, typically have narrower bid/spread asks than ETFs that trade less or hold less liquid securities. This may be true even if the ETF has a lower average daily trading volume. A larger bid/ask spread is an impost when investors need to sell, and a danger in volatile markets.
6. Index methodology
ETFs that offer similar benefits can use varying investment methodology to replicate indices. Yield ETFs are an example. Some hold more small and mid-cap stocks than others to boost capital growth, thus increasing risk. Always look under the hood to understand how the ETF chooses securities.
7. Back-testing
Smart beta ETFs often publish data on the back-testing of their methodology. An ETF that launched in 2017 might, for example, show how the ETF would have performed over the past 10 years. The analysis may be sound, but some issuers choose time periods that best illustrate their product's benefits.
8. Currency
Investors who use such international ETFs that are not hedged for currency movements must form two views: one on the outlook for the underlying securities and another on the Australian dollar's direction. Several commodity-based and fixed-interest ETFs also have currency considerations. Investors seeking to eliminate currency risk should use currency-hedged ETFs.
9. Gearing
Long-term investors should avoid leveraged ETFs. They are trading products. Volatile markets can lead to huge losses or gains in geared ETFs. Leveraged ETFs have additional derivatives risks, such as counter party and liquidity risks. An alternative is borrowing to buy plain-vanilla ETFs through margin loans, although that presents the risk of margin calls.
AFR Contributor
