[Season Finale] 5 Factors of choosing the right ETF
July 14th 2024
Photo by Robert Anasch
Master these 5 and you will get it right 99% of the time
There are five main factors for choosing the right ETF for your investment portfolio.
1) The index that the ETF tracks should represent the asset class that you want to invest in (e.g. the S&P 500, the price of gold, or US treasury bonds)
Make sure that your chosen ETF covers the index you want to invest in.
It is super important.
Some ETFs sound alike but are very different. Some names of ETFs indicate something that may or may not be the true focus of the fund.
So, make sure you have the right underlying index.
If the ETF doesn’t follow an index at all, it is an actively managed ETF. It takes even more expertise (and some luck) to find the right active manager.
Stick with passive, index-tracking ETFs.
That way you know what you’re getting into and usually incur substantially lower costs (i.e. expense ratio). Double-win!
2) The ETF must “replicate” the index, meaning it buys the actual components of the index, not placeholders like futures or other derivatives
The fund must buy the actual components of the index, not placeholders like futures or other derivatives.
If it’s an S&P 500 ETF, it should buy all 500 stocks of the S&P 500 index. If it’s a gold ETF, it should buy physical gold. If it’s a 2-year government bond index ETF, it should invest in real 2-year government bonds.
That is called “replication”.
Replication lets you, the investor, indirectly own the companies/commodities/bonds/etc. for real.
It’s important to avoid introducing other types of risks such as counterparty or credit risks.
3) The ETF’s expense ratio should be as low as possible, ideally in the single or very low double-digits (so you get to keep as much of your money as possible)
Managing an ETF undoubtedly costs money: salaries, research costs, other admin, etc. need to be paid. However, it should cost the investor as little as possible.
That’s what a fund’s “expense ratio” expresses.
The most popular index funds charge as little as 9, 5, or even just 3 basis points (1 basis point = 0.01%).
5 basis points, for instance, means that management fees of $5 per $10,000 worth of the ETF are deducted annually.
The most affordable actively managed ETFs cost around 25 to 30 basis points. That’s 5–6 times as much as the lowest charging passive funds. And many charge way more than that!
An active manager has to consistently outperform the market average (i.e. the index) to make their higher fee worth the investor’s while.
80–90% of all actively managed funds don’t reach that goal, statistically. So, stick with passive!
4) How much money the ETF manages (called assets under management): generally, the more the better, with a minimum of $10M (otherwise the risk of it closing is too high)
The biggest ETFs in the US (and the world) manage several hundred billion dollars.
Size matters.
Size expresses general investor interest and implies two things:
Liquidity (easy buying and selling)
Fair pricing throughout the trading day (less chance of overpaying when buying and receiving too little when selling the ETF).
Size also reduces the risk that a fund may be closed down by its manager because running it is not worth their while.
If an ETF cannot win the interest of at least $10 million, it may become under pressure to be closed down.
Why?
Say, an ETF charges 10 basis points in expense ratio and has $10 million in assets under management. That’s $10,000 in revenue for the management form. To run a fund, paying managers, traders, software, data feeds, regulatory and legal fees, etc., will easily cost that much money. Where there’s no space for business profit, the business must go out of business sooner or later.
When an ETF closes, you get paid out your share of the current value of the ETF’s assets under management.
That means you don’t have control over the timing of the sale. Plus, it’s a taxable event that may not fit in your tax plan at all (unless held in a tax-deferred account).
Sticking with the larger ETFs will most likely avoid such unexpected events.
5) How many of the ETF’s shares are traded daily on average: the more the better, so you can buy and sell it easily and cheaply
Heavily traded ETFs are more likely to exhibit a fair value in their market price than thinly traded ones.
Plus, the difference between the immediately available prices for buying and selling shares of the ETF (called the Bid-Ask spread) is usually lower the more trading volume there is.
If you select an ETF that is traded more than an otherwise equal competitor, you can reasonably expect to incur lower implicit transaction costs (i.e. the lower Bid-Ask-spread) and receive a more reliable price — which benefits your bottom line as an investor.
Are these 5 factors all there is to selecting the right ETF?
Well, there are more factors to consider if you want to get all nerdy.
But if you master these 5, you will get it right 99% of the time.
Thanks for reading.
Shine your light,
Cristof
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