How to Choose an ETF

An ETF, or exchange-traded fund, is an investment fund that trades on a stock exchange, just like a share. Many ETFs aim to track a benchmark index, giving the investor exposure to a broad range of assets through a single instrument.

In practice, that can mean investing in the largest companies in the world, in European bonds or in a specific sector without having to select each security individually.

The simplicity of the product does not mean, however, that all ETFs are equivalent. Two funds that look similar can follow different indices, have different structures, charge different costs or expose the investor to different currency risks.

That is why, before buying, there are a few elements worth comparing.

First, understand what you are investing in

The most important element of an ETF is the index or strategy it aims to track.

That index determines the real exposure of the portfolio: which markets it includes, how many companies or bonds it holds, how they are selected and what weight each one is given.

Before looking at the fee or the name of the ETF, the first question should be a simple one:

Does this index represent the market or asset class I want to invest in?

The ETF is the vehicle. The exposure you choose is the investment decision.

There are also a few important characteristics that help to tell similar products apart.

Physical or synthetic replication. A physically replicated ETF invests directly in the assets that make up the index, either by buying every security or a representative sample. A synthetic ETF uses derivatives to reproduce the performance of the index. This structure can allow efficient replication, but it adds counterparty risk.

Accumulating or distributing. In an accumulating ETF, the income generated by the assets is reinvested in the fund itself. In a distributing ETF, that income is paid out to the investor. The most suitable option depends on each person’s objectives and income needs.

UCITS. For European retail investors, it is common to find UCITS-compliant ETFs. These products follow a European regulatory framework with specific requirements for diversification, transparency and investor protection.

The cost does not end with the annual fee

The TER, or Total Expense Ratio, is usually the first cost compared between ETFs. It represents the annual expenses charged by the fund.

It is an important indicator, but it does not tell the whole story.

Another relevant element is the tracking difference, that is, the gap between the performance of the ETF and the performance of the index it aims to track.

If two ETFs follow exactly the same index, the one that tracks it more consistently may be more efficient, even if its TER is not the lowest.

The following should also be considered:

• buying and selling costs charged by the broker;
• the spread between the bid and ask prices;
• the size and liquidity of the fund;
• costs associated with currency conversion;
• possible tax implications.

For that reason, comparing ETFs by TER alone can lead to an incomplete conclusion.

The currency can create a false sense of security

An ETF traded in euros does not necessarily mean the investment is protected against exchange rate movements.

The currency in which the ETF is traded and the currency of the assets that make up the index are two different things.

For example, an ETF can be bought in euros on a European exchange and still have significant exposure to US companies whose shares are priced in US dollars.

Some ETFs offer currency-hedged versions. That protection can reduce the impact of currency fluctuations, but it also adds costs and is not necessarily suitable for every horizon or objective.

We explored this difference in detail in “ETFs in Euros: Are They Currency Hedged?”.

The risk depends mostly on the exposure

An ETF does not guarantee the capital invested.

Its risk depends, to a large extent, on the assets held by the fund. A short-term bond ETF has a very different risk profile from an emerging markets equity ETF.

The main risks include:

• market risk;
• currency risk;
• liquidity risk;
• counterparty risk, especially in synthetic structures;
• concentration risk, if the index is heavily exposed to a few sectors, countries or companies.

There are also leveraged and inverse ETFs, designed to deliver multiples of an index’s daily performance or to benefit from market declines. Their structure makes them significantly more complex and unsuitable for most long-term investment strategies.

Four questions before choosing

Before buying an ETF, it is worth answering four questions.

1. Which index does it track? Is that really the exposure you want in the portfolio?

2. How does it replicate that index? Is the replication physical or synthetic, and how closely has the fund followed the index?

3. What does it really cost? Consider the TER, the tracking difference, trading costs, the spread and liquidity.

4. What is the currency exposure? Understand the currencies to which the underlying assets are exposed and whether currency hedging is in place.

Answering these four questions helps identify most of the relevant differences between apparently similar products.

The ETF comes after the strategy

The choice of ETF should come after you have defined your Investor Profile, objectives and portfolio allocation.

Only then does it make sense to look for the instrument that provides efficient exposure to each asset class, with appropriate costs and characteristics compatible with the plan.

At PortfolYou, the Asset Allocation tool helps turn the investor profile into an allocation across asset classes. The Backtester then lets you analyse how a portfolio made up of those instruments would have behaved in the past, including periods of decline.

Choosing an ETF is therefore less about finding “the best ETF” and more about finding the right ETF for the role it has to play in the portfolio.

Adapted from “Como investir em ETF’s?”, originally published on the Future Proof blog.