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How to choose the right ETF

This article appeared in the September 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

This simple guide will help you pick one exchange traded fund over another.

Photo of Robin Bowerman By Robin Bowerman, Vanguard

With an ever-growing investor appetite and the available range of exchange-traded funds (ETFs) continuing to expand, the new challenge for investors and advisers alike is how to select the right ETF for a portfolio.

The Australian ETF market continues to grow at a fast pace, with assets under management hitting a record high of $12.3 billion at the end of July 2014 and 96 exchange-traded products currently trading on ASX.

(Editor's note: Learn about the features, benefits and risk of ETFs with the free ASX online course, Exchange-Traded Funds and Exchange-Traded Products.)

A detailed look at the figures for the first half of 2014 shows that the majority of growth over the six-month period comes from net inflows (new money buying ETFs). That demonstrates investors' willingness to invest in ETFs through a period of limited price growth in the market.

The choices available to this growing pipeline of ETF investors is increasingly diverse as product issuers build their suite of offerings, with multiple ETFs offering access to the same asset class.

ETFs are powerful tools because of the way they bring access to entire markets or market segments to the desktop of the individual investor. One trade on ASX, for example, can access approximately 100 per cent of all the shares on the US sharemarket and give an Australian investor holdings in 3,684 companies.

That is the sort of investing firepower that used to be the exclusive domain of large institutional investors.

Having the right tools available is a good start in any line of work, but knowing how they work together is just as important. So before getting into comparing one ETF with another the first step for any investor ought to be giving consideration to how the proposed investment fits into their overall portfolio plan and asset allocation.

Choosing what's right for you

When it comes to evaluating one ETF over another there are probably three main criteria investors should consider:

  • Coverage
  • Total cost
  • ETF issuer track record.

The first point is really about how well the ETF covers or captures the market (or market segment) you are looking to invest in. This also involves the construction of the underlying index that the ETF is tracking. Understanding what you are buying is a critical first step with any investment. With ETFs it is worth investing the time to understand the underlying index and how it is constructed, because that fundamentally dictates what you are investing in.

Based on Vanguard's deep indexing experience, we have formed certain views about index construction best practices. Most important, we believe that an index must be judged by how accurately it measures returns from a designated market segment and not by how its returns compare to those of other indices over any particular period of time.

We believe that at least five aspects of an index provider's construction methodology are critical to producing a superior index. They are:

  1. Objectivity. In our view, an index should be maintained according to an objective set of rules that leave virtually no doubt or ambiguity as to whether particular stocks warrant inclusion in the index. In the indexing world, an objective selection process leads to consistency - which in turn enhances the integrity of an index.
  2. Adjustment for "float." We believe that an index should weight its holdings in a manner that reflects the amount of a stock's "float," or availability, in the marketplace. Many companies have shares of stock outstanding that effectively are not available for purchase by investors (often representing closely held positions in a company, or perhaps cross-holdings of other companies or governments). Including these unavailable shares in index calculations can produce a distorted picture of the returns actually attainable by investors.
  3. Approach to market capitalisation. For indices that focus on companies of a particular size, we believe that the cutoffs between small-cap, mid-cap, and large-cap companies should be defined as overlapping bands rather than fixed lines. In addition, we believe these bands separating capitalisation segments should be based on the relative size of companies rather than by specific dollar amounts of market capitalisation.
  4. Approach to "value" versus "growth". We believe shares should be analysed for inclusion in a value index or growth index by using multiple criteria. Similar to capitalisation cutoffs, overlapping bands, rather than a fixed line, should define investment styles.
  5. Approach to rebalancing. All index providers periodically rebalance their indices by adding or dropping shares to ensure the indices continue to measure their designated market segments. Index funds then quickly adjust their portfolio holdings to keep in close step with their target indices, often suffering large transaction costs and making trades at unattractive prices. This periodic rush into and out of shares is counterproductive, and not at all how investment managers prefer to manage money.

We believe there are considerable benefits to using a more rational approach to rebalancing indices. Gradual and orderly rebalancing would enable index funds to manage their transaction costs from portfolio adjustments in much the same manner as other investors.

When looking at specific ETFs, these best-practice index construction factors can be used to better understand the objective of a fund and to potentially highlight differences between similar funds.

It is worth noting that Vanguard research into different index providers has shown there is no empirical evidence that any ETF or fund based on a particular provider will outperform over time.

The importance of cost

Total cost - fund expense ratio plus trading costs - is a clear way to score ETFs. As investors the one thing certain in life is that the more you pay in costs, the less you get to keep.

Small differences in fees can make substantial differences over the long term, which is particularly relevant for people investing through a Self-Managed Superannuation Fund for their retirement and by definition often investing for the very long-term.

Cost is perhaps one of the more straightforward ways to compare ETFs. However, there are some cost implications specific to ETFs that need to be considered.

An ETF typically carries a lower expense ratio than a comparable managed fund, but there are other costs to factor in. As with the purchase of stocks, investors who buy an ETF incur a bid/ask spread, or the difference in the market price to buy the ETF and the market price to sell it. The bid/ask spread is highly dependent on the liquidity in the market, the breadth of the underlying index, and the daily happenings in the marketplace on any given day, hour, or minute.

There may also be brokerage commissions associated with buying or selling the ETF, as with any stock.

Choosing the right issuer

Investors taking a long-term view also need to be cognisant of an issuer or fund manager's track record and reputation.

Expertise and years of experience managing index investments is also worthy of consideration when evaluating ETFs. The underlying index construct was discussed earlier but the ETF issuer's key role is to track, as closely as possible, that index. So tracking error - the difference between the gross return of the index and the ETF net return after fees - is the sort of comparison investors can make when assessing one product over another.

ETFs may offer different product features - dividend reinvestment, for example - which may tilt the scales for some investors towards one product over another.
While some ETF providers have cited strong cash flow into the products as proof that ETFs are a great improvement over managed funds, critics have raised concerns that they may carry more risks than managed funds. The truth is that neither is entirely true. With the "F" in ETF standing for fund, the fact is that ETFs carry similar risks and similar benefits to managed funds.

An ETF or managed fund?

When deciding between an ETF and a managed fund, consideration should be given to the following factors:

  • If the investor has, or is prepared to open, an account with a sharemarket broker, or alternatively if they are willing to have a financial planner make the ETF investments via an administration platform.
  • The frequency of investing. Brokerage fees apply when buying ETFs on the sharemarket, so ETFs may not suit investors who make ongoing, small contributions.
  • The importance of trading. Trading flexibility is a key benefit of ETFs, but if this flexibility is not important to the investor the added brokerage costs of investing in ETFs may not be worthwhile.

This is by no means an exhaustive list of the factors that could contribute to a decision to select one ETF over another. The structure of an ETF, tracking error, and the option to reinvest dividends may be equally important considerations depending on an individual investor's needs, circumstances and objectives.

Investing in an ETF is the simple part, because they trade in the same way as direct shares. Deciding between ETFs that offer the same exposure can be more difficult. It requires the discipline to evaluate the available options based on their specific characteristics and, in turn, determining if these characteristics help or hinder an investor in reaching their specific financial goals.

About the author

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia.

From ASX

If you have ignored ETFs because you do not understand them, or because they did not offer the exposure you were looking for at the time, now might be a good time to review our online course on ETFs. The course is free and no registration is required. The material is divided into topics so you can skip those you are not interested in and focus on those you are. There are lots of graphics and activities to help you reinforce what you have learned.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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