Buying a passive exchange-traded fund (ETF) should theoretically be simple: pick the cheapest one replicating the performance of the index you want to buy.
However, not all ETFs are created equal, and there is a range of criteria that needs to be considered viable investments. Below, Trustnet asks experts what investors need to check before buying an ETF.
Index
As most ETFs simply mirror the performance of their benchmark, it is important for investors to consider the specifics of the underlying index. This includes analysing the exposure to certain sectors and geographical areas.
Alison Macdonald, portfolio manager at RBC Brewin Dolphin, said this could becoming important in the current climate as the rise of the ‘Magnificent Seven’ US stocks has caused them to balloon in terms of significance to the S&P 500 as well as to global indices.
He compared it to the financial crisis, when the FTSE 100 “suffered significant declines due to its high concentration of financial stocks”.
A high concentration in a handful of stocks can be good news when they are performing well, but any adverse events affecting these companies can have a considerable impact on the index as a whole.
Moreover, some providers may change the underlying index or the methodology of their ETFs over time, which is another factor investors have to monitor.
Nick Wood, head of fund research at Quilter Cheviot, added: “This is akin to a fund manager leaving an active fund or switching styles, and is clearly a red flag if this wasn’t what you wanted to buy.”
Costs
As with any fund, cost is an important factor to consider, with Wood emphasising that simple market cap index ETFs should be very low cost. However, investors should expect to pay more for more customised ETFs.
Therefore, they should seek an ETF that charges a competitive fee relative to other similar options available on the market.
Tracking error
Jonathan Griffiths, investment product manager at ebi Portfolios, urged investors to combine cost comparison with a “thorough” backward-looking performance review.
He added: “Has the ETF achieved its investment objectives over historic time periods? If not, then gaining a deep understanding of why this is the case should be a priority for the investor.”
A way to measure past performance for a passive ETF is to look at its tracking error, which measures how effectively it replicates an index.
Wood said: “This will vary for a number of reasons and different ETFs of the same index will produce different results, so ensuring it is aligned as closely to your target index is very important.”
A tracking error of zero indicates a perfect replication of an index’s performance. As a result, investors should look for ETFs with a tracking error as close to zero as possible.
Physical or synthetic
To track the performance of an index, ETFs can physically replicate it by holding all of the actual securities within that index or by using an alternative way known as synthetic replication, which utilises derivatives.
Wood said: “It is better to have full physical replication if possible as synthetic will bring in some extra complexities and risks. Synthetic ETFs introduce counterparties and thus there are risks to capital if any of these get into financial or operational difficulties.”
Liquidity risk
Liquidity – how easy and quick it is to trade the ETF at a reasonable cost – is another factor that investors should take into account.
For that purpose, Griffiths highlighted the ETF’s trading volume and its bid-offer spread as the two most prominent measures of liquidity. He also stressed that the liquidity of an ETF will be impacted by the liquidity of the individual securities it holds.
Macdonald added: “The ETF market has vastly expanded in recent years, enabling investors to target specific trends and themes, some of which can be quite niche. The more niche the market, the more likely you are to run into liquidity risks if you want to sell.”
Leverage
Finally, investors should keep in mind that some ETFs use leverage, which means they utilise derivatives and borrowing to amplify the returns of the benchmark index.
While leverage can lead to greater returns, it also increases volatility. Moreover, leveraged ETFs tend to attract higher fees and may have complex tax implications.
Macdonald concluded: “They’re not really designed to be held as long-term assets and are more frequently used by day traders – not one for the inexperienced investor.”