7 tips to choose the right ETF

ETFs had come a long way from 1993 when the United States launched the first ETF. Since then, ETFs have been a vehicle to grow investor wealth manifold.

However, it is paramount that the investor should know how to choose the right ETF. He should base his choice upon various underlying qualities of the ETF. 

 

Selection Criteria for how to choose the right ETF

1. Fund Size  

Any investor must bear the fund size before investing in the ETF. Fund size means the Assets Under Management (AUM). A large AUM implies that many investors are interested in this ETF.

The AUM can be a proxy of a soundly-managed fund. They also have higher liquidity, enabling the investor to offload his ETFs with comparative ease as and when the need arises. With a larger fund size, the fund is most likely profitable and is safe from liquidation danger.  

2. Age of the ETF

The age of the fund is usable as a proxy for the reliability of the fund. A fund that has been around for a considerable amount of time must have a proven track record. Newly launched ETFs generally have a lower trade volume, with no definite reason.

There can be two reasons why an ETF has a low trade volume. The trade volume could be lower because it is relatively new or low because of weak demand. New and novice investors should stay vary of such ETFs. The test of time is the safest bet for a beginner.  

3. Volume 

Higher the ETF volume, lower the bid price spread, and more is the demand for that ETF. This line sums up the entire game of the book. An investor must look at the volume of the ETF before investing.

Analyzing and carefully studying the declining trend and then picking up the ETF is the way to march ahead. 

4. Expenses

 

The greatest thing about ETFs is that they cost less than traditional mutual funds. Minimizing costs is the best way to maximize returns. These are the costs that eat up an investor’s profit. The lower the costs, the better.

An ETF charges an expense ratio for management; thus, this has to be minimal. So, comparing the expense ratio is a must. The broker charges the transaction cost; this also is a cost whilst trading in ETFs, this also needs to be minimized. 

5. Tracking difference 

An ETF tracks the underlying index to the best of its capability. Some ETFs replicate the index entirely by adding all the securities in the exact proportion present in the index.

For instance, if an ETF replicates the Sensex, it will have all the guards in the same ratio of the Sensex in its basket. On the other hand, some ETFs will sample some securities from the index and make an ETF.

The aforementioned basketing is called a sampled strategy. Both these ETFs may either underperform or overperform their underlying index. The deviation in performance can be due to faulty replication or the expense ratio that eats into your potential gains.  

For example, an ETF has an expense ratio of 0.2% tracks an index growing at 10%, your profits are automatically reduced to 10-0.2=9.8% compared to the index. Thus, tracking difference plays a crucial role in ETF selection.

Source: Corporate Finance Institute 

6. Benchmark 

Studying the underlying assets of an ETF helps gauge its performance of the ETF. Thus, the underlying benchmark is a gauge of its performance. From the diversification point of view, having a broad-based ETF is preferable.

Taking a closer look at the underlying assets and their weights is also essential, as it will ensure that the ETF you have invested in suits your goal and investment strategy.  

7. Structure of the ETF 

Check whether the ETF is a physical ETF or a synthetic ETF.  

• Physical ETF: It holds the underlying assets or securities of the index, which the ETF tracks in similar or representative proportion according to the fund’s strategy. 
• Synthetic ETF: These ETFs seek to replicate the index using complex derivatives. For instance, an ETF tracing crude oil prices will not hold barrels of oil but will invest in oil futures. A counterparty would be responsible for delivering the return if oil reaches a specified price level.  

A physical ETF is more transparent and accessible to understand than these synthetic ETFs but will protect from counterparty risks. However, synthetic ETFs provide better access to specific markets than physical ETFs. Choose wisely! 

Following the above steps and keeping in mind your investment strategy and goals is the way to go forward. 

Consult our ETF expert to discuss the right plan.