How to choose an ETF: a guide to mastering ETF investing

With an increasing number of ETF offerings flooding the market, the sheer variety can often leave investors feeling overwhelmed and uncertain when it comes to selecting the right one. In this article, we aim to demystify the process of choosing an ETF and highlight the crucial factors you should consider before making a decision.

An ETF, as you may already know, is a hybrid financial instrument that combines the characteristics of both an investment fund and a stock. Essentially, it comprises a diversified portfolio of assets (similar to investment funds) that are traded on the stock exchange and can be bought or sold at market prices throughout the trading hours.

Choose an ETF strategy

Choosing the right strategy is a critical step when delving into the world of stocks and investments. The challenge lies in the fact that a myriad of strategies exists, but unfortunately, many of them end up underperforming the market index or result in losses over time. This is often due to a lack of rigorous backtesting, reliance on anecdotal or selective evidence, or the use of subjective rules and hunches that are challenging to replicate and test.

To avoid falling into such pitfalls, it’s essential to opt for a proven strategy—one that has demonstrated its effectiveness, possesses robustness for future performance, and operates with clear and replicable rules.

Moreover, the chosen strategy must align with your risk tolerance, volatility preferences, time horizon, and investment objectives. Remember, risk and volatility are distinct elements that should be carefully considered. Choosing the right money management strategies is key to securing long-term profits.

Types of investing strategies

Let’s explore some of the time-tested strategies that have shown positive results:

• Passive indexing. Recommended for periods of more than 10 years meeting the requirements of diversification, rebalancing and regular income. This strategy uses ETFs that preferably follow broad and diversified baskets of assets for the core of the portfolio, including dividend kings or dividend aristocrats.
• Rotational. This tactical approach involves investing in ETFs based on countries, regions, sectors, or industries. It is advisable to view these ETFs as complementary components to your portfolio. For example, the portfolio could include a mix of the best ETFs in India, the best NASDAQ ETFs, and the best FTSE100 ETFs.
• Trend strategies. This type of strategy is best executed through automation to eliminate discretionary decisions and cognitive biases. Typically applied for short to medium-term periods, it may involve using ETFs with derivatives for short-term positions and others without derivatives for medium-term positions.
• Tactical asset allocation (i.e., active management): Tactical asset allocation strategies are active and require ongoing monitoring and adjustments based on changing market conditions. These strategies may be suitable for investors who are comfortable with more frequent trading and have a keen understanding of the risks involved. This strategy may include leveraged products, ETF vs ETC vs ETN tied to popular or thematic indices.

Keep in mind that these four strategies are just a selection from the vast array of options available. Each strategy requires different tools and suggests a certain type of ETF for optimal implementation.

For instance, thematic or niche ETFs might not be suitable for passive portfolios as they can increase the risk of market volatility and subsequent returns.

Determining investing goals

Determining your investing goals is crucial when considering ETFs, just as it is with any other investment products. Knowing your time horizon, or how long you intend to keep your money invested based on the chosen strategy, is essential.

Regardless of whether your strategy is short or long term, it’s important to understand that the stock market and markets, in general, can be affected by unexpected events.

Therefore, testing the investment approach multiple times increases the likelihood of success. Even a strategy with an 80% probability of success could encounter unfortunate outcomes. Consequently, it’s advisable to test your strategy rigorously and only invest capital you can afford to lose.

For most ETF investors with a long-term perspective, a well-constructed passive portfolio is often the most viable option. Due to factors like costs, taxes, and time commitment, passive investing tends to be advantageous for long-term investors.

Determining investor profile

Determining your risk profile and volatility tolerance are two other crucial considerations that should be in sync with your time horizon:

• Risk Profile: This represents your capacity to withstand potential capital losses.
• Volatility Profile: This reflects your ability to endure short and medium-term market fluctuations.

Matching your strategy with your risk and volatility tolerance is essential. For instance, opting for a strategy that involves frequent short or medium-term trades might not be suitable if you cannot handle high volatility or if you lack sufficient time to recover in case of early setbacks.

Passive portfolios with ETFs typically adopt a long-term vision, sidestepping the need for precise market timing. As a result, short-term corrections typically do not pose significant issues for this type of investment. Nevertheless, it’s crucial to acknowledge that market corrections will occur, and you must possess the resilience to stick to your investment strategy.

Additionally, while transitioning between a portfolio focused on growth and one centred on capital preservation and income, careful planning is essential. Avoid attempting to compensate for starting late by setting unrealistic future expectations or seeking excessively high short-term returns from the market. Assuming a higher risk than you can handle could be detrimental.

In general, certain principles are applicable to passive investment strategies with ETFs:

• Regularly adding funds to your investments
• Diversify across different asset classes.
• Embrace a long-term outlook for your investments.
• Adjusting the portfolio periodically to maintain the desired asset allocation.

Determining your comfort level with volatility and risk is essential, and the following factors typically come into play:

• Younger investors often possess a higher capacity to tolerate volatility and risk.
• The greater your capital, the more volatility and risk you may be able to endure.
• A longer investment horizon generally allows for greater tolerance of volatility and risk.

What elements should we take into account when choosing an ETF?

When choosing an ETF that best suits our needs and strategy, there are several key elements to consider:

TER (Total Expense Ratio)

This represents the total annual expense ratio (expressed as a percentage) of the ETF, encompassing management fees, deposit fees, internal charges for intermediation, and audit fees. The lower the TER, the better, as it directly impacts the final return.

For long-term investments, ETFs with lower TERs are generally more favourable.

Tracking error

The tracking error measures the deviation of the ETF’s return from its benchmark. A lower tracking error indicates more efficient replication. Ideally, the ETF should closely mirror the index, although outperforming the index is also desirable.

The tracking error of an ETF can be easily found on the ETF’s prospectus.

Exposure and benchmark

ETFs cover a wide range of indices, offering investment options in various assets. It’s essential to review the portfolio’s composition to ensure it aligns with your preferences, such as geographical diversification, sector exposure, use of derivatives, and more.

Markets & issuers

Consider the market where the ETF is listed, as different markets may have varying costs and taxes. Additionally, pay attention to the ETF’s base currency, the currency it is quoted in other markets, and the currencies of the assets held in its portfolio, as this introduces exchange rate risk.

Also, ETFs listed on other markets are only available for trading during the specific market’s trading hours. For example, if you trade the best NASDAQ ETFs, you need to consider the exchange’s trading hours and difference in timezone, which are explained in this US stock exchange calendar.

Volume

Adequate trading volume is crucial for ETF liquidity and price efficiency. Higher trading volumes contribute to better market-adjusted prices. Ensure the ETF has sufficient volume to meet your trading needs.

Spread

The spread represents the difference between the purchase price and the sale price of an ETF. A lower spread indicates better liquidity and efficiency in the market. It’s essential to choose ETFs with low spreads to minimise implicit costs.

Leverage

Some ETFs use leverage to amplify returns, usually x2 or x3, through derivative instruments. While leverage offers the potential for higher gains, it also introduces higher risks, as losses can also be multiplied.

Dividend policy

Dividend ETFs may have varying returns based on their dividend policies. Depending on your investment goals, ensure the ETF’s dividend policy aligns with your preferences, whether you seek current income or capital appreciation.

More specifically, some ETFs may use dividends to increase holdings (by reinvesting dividends, i.e., accumulation funds), while other funds may distribute the dividends to the fund holders (i.e., distribution funds). Considering accumulating vs distributing ETF differences is also important for your bottom line.

Currency

Investing in ETFs from markets outside your country involves currency risk. Consider whether you are comfortable exposing yourself to fluctuations in foreign currencies.

Replication method

ETFs can employ either physical or synthetic replication to track the benchmark index. Physical replication involves buying the underlying assets, while synthetic replication involves using derivatives (such as swaps). Both methods have their pros and cons, and investors should be aware of the associated risks.

Although synthetic replication reduces tracking error, it has enhanced risks to investors (such as credit risk).

Alternatives to investing in funds

• Investing in commodities
• CFD trading
• Options trading
• Futures trading
• Stock market for beginners

Choosing ETFs: summary

Selecting ETFs with lower costs, maintaining geographical diversification, and making periodic contributions align well with passive management principles. Reducing costs and effectively replicating the index are key to achieving a return close to the benchmark over the long term. Additionally, diversifying across different regions and asset classes helps mitigate risk, while regular contributions minimise the impact of timing on investment performance.

FAQs