The ChoosaBroker Trading Academy

9.2. How to Select an ETF

Exchange traded funds (ETF) have greatly evolved since the early 1990s when most funds tracked either of the three U.S. equity benchmarks – S&P 500, Dow Jones Industrial Average or Nasdaq 100. Given the exponential growth in the number of ETFs, and the exotic variety of underlying assets, finding the one that’s best suited for you can be tricky. Investors should consider the following 8 factors before zeroing in on their fund.

01. Setting an Objective

Whether you are saving for retirement or for your next car, it’s important to first decide what you are trying to achieve and then link your investment goals to serve that purpose. For example, short term bond or money market ETFs may be suitable if your financial needs are immediate, while equity ETFs are better suited for longer time frames. Alternatively, if you strive for regular income from your investments, a dividend ETF will be the ideal option. In short, knowing why you need to invest, and when you want the returns, can help you choose wisely.

02. Researching Potential Fund Managers

The number of ETF fund providers continues to grow at a rapid pace. The addition of new entrants on a regular basis makes it very important from an investor standpoint to assess who’s who and what all the issuers are offering. When selecting an ETF, take the time to investigate the provider’s experience in both the ETF sector and the global financial markets in general. Have they been around for a long time? Can their market insight yield the returns you seek? These are just some of the questions to ponder.

03. Understanding the Inherent Costs

Management fees, often termed as expense ratios, are a key factor to consider before choosing a fund. However, they aren’t the only likely costs that need to be weighed. For starters, investors would do well to compare an ETF’s tracking error, which measures how well the fund is tracking its benchmark index. If the ETF underperforms the index, an investor could end up losing money. Everything else being identical, an ETF with a lower tracking error is superior to one that displays a greater level of error. Sales commissions are another important cost to be considered, especially if an investor intends on trading more frequently.

04. Examining the Asset Level

To be deemed an effective investment option, an ETF must enjoy a minimum assets base. A widely accepted threshold is $10 million. A fund with assets less than this dollar figure will likely have insufficient investor interest. And just like stocks, lower volumes translate to poorer liquidity and wider spread. Daily trading volumes in the most popular ETFs can run in to several millions of shares. In general, the higher is the investor interest in a fund, the greater is the volume, and tighter the bid-ask spreads. These are important considerations, especially for short term traders.

05. Seeking for Diversification

Given the wide variety of assets that ETFs track, it’s important that an investor has a basic understanding of the risk-return profile of the different markets. From a diversification point of view, it is always desirable to invest in a fund that tracks a broader benchmark, rather than a narrow index with a specific geographic or sectoral focus.

06. First Mover’s Advantage

The first ETF issuer in any sector has the odds stacked in his favour, provided the fund house enjoys a decent market reputation. The first mover draws a big chunk of investors, before others hop on to the bandwagon. Investors are therefore advised to avoid ETFs that are cheap duplications of an original theme, because they often fail to attract enough investor interest.

07. Taxation

Since different ETFs are structured differently depending on how they gain exposure to the underlying asset, a fund’s tax treatment is contingent on both the asset classes it contains and its particular structure. Investors need to have a fair enough understanding of how an ETF will be taxed before committing funds to it, because negative tax surprises have the potential to eat in to their returns. In most cases, ETFs are tax efficient when compared to conventional mutual funds in the corresponding asset category.

08. Regulatory Risk

Synthetic ETFs, which utilize derivatives such as swaps to mimic the underlying index, are attracting regulatory attention from the Financial Stability Board. The primary areas of concern include the lack of compliance and the lack of transparency in products. Avoiding such kinds of funds can help protect your savings from future uncertainty.

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