Choosing the right ETF for you
Exchange-Traded Funds or ETFs are investment funds that hold assets like stocks, bonds or commodities and are traded on stock exchanges – but how do you decide which ETF to choose?
With thousands of ETFs to choose from, you need a strategy to narrow down your selection quickly, without needing to analyse every ETF individually.
Here are some of the different characteristics you can use to choose an ETF that is a good fit for you.
Choose an ETF provider
You can start by looking at the ETF provider, which may be a fund company or one of the major banks.
Look for a well respected financial institution and especially one that is rated highly by its customers.
Some of the areas in which a good ETF provider should perform well include:
- Publicly available product details and supporting documents.
- Regular updates to key information.
- Clear, understandable presentation of data.
You may have your own priorities in terms of how the ETF provider treats you as a customer; don’t be afraid to put these first before you even start to narrow down the specific ETF you choose to invest in.
ETFs can allow you to invest in a variety of different asset classes, such as bonds, commodities, equities and real estate investment trusts (REITs).
You can choose just one of these, or you can diversify to spread your investments across multiple asset classes and different markets.
Some ETFs have an international focus, while others may be focused on a specific national economy, allowing you to target countries that are likely to prosper in the immediate future.
The narrower the focus, the higher the risk – a broader index focus is a way of protecting against volatility in a specific market or economy.
Again, there are different levels of focus, including ETFs with global reach, others with national reach (e.g. the UK FTSE All-Share index) and even more specific industry-focused or company-focused ETFs.
You can keep a diverse portfolio by choosing an ETF with a broad index, or by investing in a broad selection of different ETFs, each of which has a narrower focus in its own right.
More characteristics of ETFs
There is a long list of different characteristics of ETFs, any one or more of which you can use as your selection criteria.
Some examples of this include:
- ISA eligibility
- Ongoing charges
- Tax status
It’s fairly clear how some of these ETF criteria combine to create more confidence in the fund, for example an older fund with good historic performance and a large present-day fund size is all an indication of good management and investment practice.
Consider the ongoing cost of investing in an ETF. This includes transactional admin charges and annual fees, for example:
- Transaction fees
- Taxes payable
- Ongoing Charge Figure (an approximate annual management fee)
- Total Expense Ratio (like OCF, an admin fee for legal, marketing costs etc.)
While there is no single figure that includes ALL of an ETF’s fees including all taxes and transaction costs, you can calculate a reasonably accurate estimate using the ETF’s annual return data.
A key element in this is the Tracking Difference, a measure of the gap between the potential return of a particular index, and the real-world return achieved by the ETF.
This gap is created by the money lost in management fees and other operating costs, and you may wish to focus more on ETFs that minimise their Tracking Difference.
Using your ETF profit
ETFs typically specify how they treat any income generated by a positive return on their investments, and this may be in one of two main ways:
- Distributing ETFs pay out any profit or income as interest or dividends that you can then spend as you wish.
- Accumulating or Capitalising ETFs reinvest their profit so your investment grows over time, which can save on transaction costs.
The question here is whether you want to receive a cash dividend when the value of the ETF rises, or whether you want to automatically use that income to buy more shares in the ETF.
If you have a diverse portfolio and prefer to let it grow over time, an accumulating or capitalising ETF can do this with fewer transaction costs and admin time on your part.
However, if you have focused on short-term returns from high-risk ETFs, you may want to extract that value as soon as it is generated.
A Personal Choice
There is no one way to choose the right ETF – it depends on your preferred provider, risk profile, market, currency, national or international economy, and so on.
However, by applying some of the methods outlined above, you can quickly start to narrow down the field, making it much easier to choose a suitable ETF from your shortlist.
Here at UK Investor we know we are dealing with investors from a range of different levels of experience, but it would be remiss not to remind you that putting 100% of your available capital in into a single ETF is not usually the best thing to do. Unless of course, you have insight on a sure-fire bet. Diversification, as always, is the order of the day to spread risk and will allow you to use a range of strategies to build a portfolio that suits you better overall
Disclaimer: The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.