How to Choose the Right Exchange-Traded Fund (ETF)

On May 8, 2020 at 9:56 am UTC by Osaemezu Ogwu · 13 min read
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Photo: Shutterstock
Photo: Shutterstock

Here’s a guide on all you need to know about exchange-traded funds (ETFs) and what it takes to choose the right ETF eliminating all the related risks.

Knowing how to choose the right Exchange-traded Fund (ETF) becomes easier when you have invaluable guidelines to work with. You’ll be able to avoid certain pitfalls even as a new investor and at the same time, make significant returns from your investment.

What are ETFs?

Exchange-traded funds (ETFs) are funds that are tradeable on exchanges. For this reason, they offer investors an opportunity to reap profits. While ETFs can be classified as index funds, they attract lower fees which could be lower than that of regular index funds. The same applies to the reduced taxes investors enjoy and the more liquid nature of these funds, unlike regular securities.

Furthermore, the net asset value (NAV) is determined using the value of the ETF’s current net assets. This value is further slashed by the number of outstanding shares. The NAV is publicized every 15 seconds of each trading day.

NAV, however, is not the market price of the ETF. It can be likened to the stock price or the price the company offers its shares. NAV is also fixed at the close of the daily trading session. Nonetheless, the price of an ETF is greatly influenced by demand and supply. As a consequence, the market price of the ETF could differ from its NAV.

Over and above that, investors get rewarded with part of the fund’s profit and these returns are paid consistently. How much an individual is rewarded is determined by the number of shares they had acquired. And a comparison between ETFs and mutual shows that there are certain similarities. For starters, investors get to buy securities of their choice. The asset purchased is then used to track the stock index.

History of ETF as an Asset

ETFs went live over a decade ago, and they have gradually gained popularity over the years. The investment in ETFs has also spiked over the course of the years. The same can be said about the surging number of ETFs, which has given investors a range of options to work with. Nevertheless, the number of ETFs is still considerably lower compared to the mutual funds we have today. The latter sits at thousands even though ETFs can still grow significantly in the near future.

What’s more, the early days of ETFs can be traced back to SPDRs. The SPDRs emerged in 1993 and it keeps track of the S&P 500. The SPDRs were also popular and it brought the launch of ETFs tailored to other equity indexes. An example is the Nasdaq 100.

There are also different investment options provided by ETFs, and these options have varying levels of equality. For example, certain funds may be closed down or liquidated more easily due to low investor interest. This makes it essential for investors to choose ETFs carefully to ensure they curb their risk to the minimal.

Why Investors Like ETFs

There are several reasons why investors like ETFs and some of these are:

Costs

The cost of investing in a good number of ETFs is lower, unlike traditional mutual funds. This is because these ETFs demand low fees.

Taxes

There’s also the advantage of lower taxes for ETF investors. The structure of these funds makes them more tax-efficient when compared with mutual funds. In this case, fund managers are not required to buy and sell stocks every so often. They may be required to make these transactions if there are changes to the component of the Index which the ETF is to track. These changes can occur as a result of a merger between companies or closure of a business.

Diversification

Individuals can choose to make an investment in a certain part of a stock market. This can be stocked with small capitalization or those targeted at emerging markets. There is also the advantage of settling for a stock as a whole.

Transparency

It’s easy to tell what an ETF holds given that they are used to track an index. The latter goes contrary to traditional mutual funds whose holdings are less exposed. These holdings may be revealed after delays and at certain times in a year. It is, however, worth pointing out that this does not apply to mutual funds that are tailored at a specific index.

User-Friendliness

It’s easy to buy and sell ETFs irrespective of the time of the day. As such, investors can always sell their shares and leave the market whenever they want. This strategy differs from mutual funds that can be priced once at the close of the trading. The latter may not be a concern if you’re making a long term investment.

While ETFs offer these benefits, it still comes with a loophole. Here, a brokerage commission is to be paid each time investors buy shares or sell them. The commission to be paid can be around $20 for each trade. The charges also differ depending on the broker used. And this fee may potentially add up if an investor tends to buy more shares every month. For this reason, investors are often advised to settle for traditional mutual funds if they buy small amounts each time.

Should You Buy an ETF?

There are several factors you need to consider to help you determine if you should invest in ETFs. This investment may be ideal depending on where you’ve sourced your capital from. For instance, ETFs become a good choice if the capital is tied to an old 401(k) as well as an IRA.

On the contrary, mutual funds would be ideal for an investor that wants to increase their investment every month. In this case, investors will be able to purchase these funds and escape brokerage fees. And the regular commission that is to be paid can tell on the returns. With that in mind, here’s a more detailed outline of when you should invest in an ETF.

Minimum Requirements

ETFs become a great alternative to mutual funds given their minimum investment. Mutual funds require around $2,000 as the minimum. Accordingly, there’s the option to use three different ETFs in your portfolio.

Over and above that, you can ensure your return is high when investing in ETFs by taking some factors into consideration. These are:

Lower Commissions

First off, it is useful knowing that ETFs can be purchased from a broker or using a brokerage account. Potential investors can fall back on online brokerages that charge less expensive commissions.

Extra Fees

Some ETFs are riddled with fees that can take a certain percentage from your returns. Regular index funds, for instance, do not come with an extra feed. However, if you opt for a lifecycle fund, you may want to determine if it has a management fee. The funds invest in several stocks and bonds and their combination may turn even more conservative when an investor’s retirement draws near.

How to Choose the Best ETF: Factors to Consider

ETFs track indexes that have gained reputation whereas others track indexes of a less popular aspect of the market. The former is a better option, unlike the latter which could increase your risk.

Widely Traded ETFs

Irrespective of the amount you’ll be paying for commissions, it is important to settle for a brokerage firm that offers what you actually need. For example, some firms offer only selected ETFs. And if that’s the case with the firm you are about to choose, they also need to offer ETFs that are used widely and traded easily.

High-Quality ETFs

It’ll be more rewarding in the long run to have chosen a high-quality ETF. This is an ETF that aligns with your investment plan. However, an evaluation of ETFs is needed before you can ascertain which is the best fit.

Consider Costs

You can resort to the expense ratio to determine the cost of an ETF. It is important to know this cost even before you make your first investment. The expense ratio, for instance, is deducted from an investor’s account in a bid to pay the annual fees required. This ratio differs from the brokerage commissions that are still levied each time shares are bought or sold.

Consider Taxes

The taxes that will have to be paid for making this investment is another factor to consider. Although several ETFs are tax-efficient due to their structure, some adopt the structure of less-static indexes whose trades occur more often. This type of ETFs may increase capital gains costs.

Consider the Source

The source of the ETF you’re investing in is important. There may be several companies overseeing a good number of funds. Three major companies are overseeing several ETFs around the world. These companies including BlackRock, Vanguard Group, and State Street handle as high as 83 percent of the ETF assets. Therefore, it established investors’ confidence that they have a good record of managing funds in the best way.

Familiarize with Market Players

Several companies offer ETF shares and their shares are quite popular. Ones you may come across more often are Vanguard ETFs, SPDRs, iShares amongst others.

Choosing an ETF

When it comes to choosing the best ETF to invest in, there are several factors you should consider. Some of these factors include:

Asset class

ETF holdings consist of stock and bonds, and the duo is the most popular assets in this holding. However, some ETFs are made up of alternative investments, currencies, etc. It’s also possible to have a fund comprise of a combination of different asset classes.

On the other hand, it is often advised to make investments in an ETF that is made of a widely used index. This choice is to be made over an index in a narrow industry. In the same vein, consideration has to be given to the minimum assets an ETF can have. A threshold of $10 million is recommended and one with a lower threshold may yield lower interest from potential investors. The low-level interest could also mean poor liquidity.

Geography

There are ETFs whose holdings are global investments whereas there are some, whose holdings are tailored to specific regions. These funds can also focus on new or developed markets, as well as states or countries.

Segment

Assets held in an ETF can be categorized using certain metrics. These metrics can be company size, the industry, amongst others. An example of an asset that relies on these metrics to be categorized is the equity-based fund.

Investment Style

ETFs are a good way of expressing an investment strategy. Some of these strategies include making an alignment of investments with values. Likewise, investors can focus on investments that will be managed actively. In this type of investment, the managers may have to make modifications regularly.

Holdings

The holdings of an ETF are revealed to the public, thereby bring about transparency. And this level of transparency is what attracts most investors to ETFs. Accordingly, an investor can know the mix an ETF has before making an investment.

Expenses

There are often expenses to be made to cover certain ETFs. There’s the expense ratio which is used to cover the annual administrative expenses. For ETFs, 0.52 percent was charged for average index equity whereas 0.31 percent was charged for an average index bond. There have been expense ratio fees going as high as 9.2 percent.

Performance

The performance of the fund you’re about to invest in could tell you a lot. Therefore, considerations have to be given to the historic performance of the fund, whether these performances were impressive or unimpressive.

Trading Activity

The trading activity of an ETF is essential since it lets an investor know the daily trading volume of such an ETF. The trading volume informs you of the liquidity of the fund. And a higher trading volume shows its easier to exchange the fund for another. Much more, this trading volume may even amount to millions of shares in some cases. There are also ETFs whose trading volume is extremely low.

Tracking Error

ETFs may track their indexes closely, however, there are ETFs that do not take the extra time to track these indexes closely. Whichever is the case, it is better to have less tracking error compared to one that is very significant.

Market Position

An ETF fund that is the first of its kind has a competitive advantage. This is because the first issuer could potentially get more shares of an asset. And this is even before other companies offer ETFs targeted at the same niche. Accordingly, it is important to settle for ETFs that are an original idea, and not a copycat of the original. A unique ETF will attract more investors and be a strong competitor to its rivals.

Risks Associated with ETF Investments

Like any investment, there are certain risks associated with investing in ETFs. Some of these risks include:

Liquidity

Depending on the ETF you’ve selected, it may be difficult to buy or sell and at the share price you want. This can be tied to the low trading volume of the ETF, thereby making it harder to enter and leave positions. Accordingly, potential investors need to review the assets offered by the fund, the daily trading volume, and even the duration the fund has traded.

Close Down

ETFs may also close down for a number of reasons. Top on the list is the fund’s inability to handle administrative costs. A close down may also be due to the low number of assets offered by the fund.

On the other hand, ETFs that are closing usually notify their investors. This notification may be sent in advance and a month to the closing date of the fund’s trade on the market. Investors, therefore, have enough time to make a decision on their investment even before the fund’s close down. A choice of which decision depends on which will work better to protect their funds.

Accordingly, investors may opt to sell their shares prior to the date set for the close of the fund’s trading. This approach may be adopted if the investor feels that the share’s price may tank significantly in the short term.

In line with that, an investor could hold their shares until its time for liquidation. The shares may be sold weeks after the company would’ve liquidated and even shared the net proceeds. This approach is suitable for ETFs that invest in sectors that are not volatile. Irrespective of which move the investor makes to savor their money, they may still have to deal with taxes that will be levied on this investment.

Conclusion

A good idea on how to choose the right ETF will help you select the gem among the stones. Therefore, you can fall back on these tips to ensure you make the most of your investment. You get to pay less commission, find an ETF with high liquidity, and one whose company has a unique idea in place. Coupled with that, you’re in the right position to ascertain if ETF is suitable for your investment goal or you’re better off with traditional mutual funds.

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