The beauty of ETFs is that they provide broad diversification across different asset classes and locations. Exactly what you want when building the bedrock of your portfolio as a beginner. But that doesn’t mean it’s safe to invest blindly into the first ETF you see. Like anything with investing, research is your friend.
To help guide you down the road of asset classes, fees, sectors, and issuers found on ETF street, here’s a shortlist of factors worth delving into before committing to an ETF.
What is an ETF?
First things first, let’s talk about what an ETF actually is and what purpose they serve for investors like you and me.
According to Investopedia, an exchange-traded fund (ETF) is a type of security that involves a collection of securities such as stocks that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies.
Although that definition is great, I always learn better by example. So for example, The Vanguard MSCI International Index (VGS) is an ETF listed on the ASX (Australian Securities Exchange) that aims to track the return of the MSCI World ex-Australia Index. VGS provides exposure to many of the world’s most prominent publicly listed companies in major developed countries and holds over 1500 stocks. To ensure the ETF issuer tracks the index correctly, they own the underlying assets, which in the case of VGS are companies like Apple, Microsoft, and Alphabet to name a few. That ownership is then divided into units and listed on a stock exchange to form the ETF.
Now before we go any further, please know that all of the information discussed below can be found on the ETF issuers website. Think Vanguard, BetaShare, iShares, etc. Simply search the specific ETF you’re looking for and you’ll be directed to where you need to be. I’m sure you could have figured that out yourself, I just like to clarify things.
1. What Asset Class is the ETF Tracking?
Fortunately, there are loads of ETFs available for investors to choose from these days, each with their own nuances. While this is great in theory, so much variety can be paralyzing for the beginner investor.
The first step I take to break down an ETF is to understand what asset classes it’s invested in. Today you can find ETFs tracking a mixture of gold, government bonds, property, stocks. The list goes on. What’s important when selecting an ETF is that you diversify across a mixture of asset classes weighted to suit your specific situation.
For example, if you’re in your 20s or 30s, there isn’t much point investing the majority of your portfolio in bond ETFs. Being in your 20s or 30s means your investment horizon is much longer than someone in their 60s, translating into a situation where you can generally afford to invest predominantly in riskier asset classes with the potential for higher returns like stocks (equities). Again, this is dependent on your personal situation and appetite for the risks involved with owning stocks.
2. What Region Does The ETF Cover?
Okay, so we know what asset(s) we’re investing in, but what about where we’re investing? While it’s important to diversify across asset classes, it’s equally important to diversify across regions. You never want to be solely exposed to one country or continent because you never know when its financial winter will come. Take Japan, for example, in the late 80s the Japanese stock market collapsed and has never returned to its highs since. That’s over 30 years of negative returns and one bloody long winter! Meanwhile, the S&P 500 returned roughly 5% P/A over the same period (not including dividends).
When building a portfolio of ETFs it’s pivotal to ensure you’re diversified across a number of regions. You never want to invest your future into a single country or asset class.
3. Who Is The ETF Issuer?
These are the girls and guys managing the ETF, the ones overseeing its operations to ensure their products create shareholder value. The most famous of all issuers is Vanguard, but there are a host of others offering great products.
When analyzing an issuer, I like to go through a checklist process, which goes through 3 sets of criteria each issuer has to pass. And guess what? I’ve listed them below.
- Does this issuer have a good track record? You want to stick with an issuer who has been around for a long time and has a proven track record of reliability. Vanguard is by far the standout for me here.
- How many ETFs do they run? Anything over 50 is great!
- What is the size of the ETF? The larger the ETF, the less likely it is to close down. Bigger ETFs are also more efficient and easier to buy and sell. Try to avoid anything with less than $100 million under management as a rule of thumb.
4. Fee, Fees, and Fees.
Excessive fees are the silent killer that will erode your returns away year after year. Although fees are known to be lower in index-tracking ETFs in comparison to actively managed funds, they can still creep up to higher levels than you’d imagine. Here are the fees you should be aware of.
The management fee is one charged by the issuer and is essentially their slither of the pie for managing and overseeing the operations of the ETF. This fee is usually described as a percentage of your assets. For example, if your ETF provider is charging 0.1% P.A., you’ll be charged $1 on every thousand dollars invested. The management fee for ETFs mostly includes costs associated with an administration like auditing, accounting, and custodian fees.
Now don’t be fooled. It’s not very complicated to manage an index tracking ETF, mainly because all of the trading involved is done by wizbang computers and algorithms, meaning there isn’t much need for human decision making like there is in actively managed funds. All this means is that investing in passive ETFs is usually cheaper than going down the path of active management.
When assessing the management fee you should avoid paying more than 0.5% in management fees. As mentioned earlier, It’s not overly complicated to run an ETF. On the contrary, you shouldn’t settle for an insanely cheap ETF either. There’s no such thing as a free lunch these days so the issuer must be profiting or making a saving from somewhere.
Buy/Sell Spread Fee
The buy/sell spread fee or otherwise known as the bid/ask spread fee is a small cost easy for most investors to miss in their research. In all trades, Investors buy at the ask price and sell at the bid price. As the ask price is always higher than the bid price, this incurs a fee known as the spread.
For example, if a prospective buyer bids $5.00 per share for an ETF, and the seller set’s an ask price of $5.25 per share, there is a spread of 4.8% or 25 cents.
Spreads are an indication of supply, demand and liquidity. If demand for an ETF is high, the spread is generally lower and if demand is for an ETF is low, the spread is higher. And as i’m sure you’ve figured out by now, the lower the spread, the smaller fee you need to pay.
A brokerage fee is paid to your selected broker each time you buy and sell shares on the stock market, including ETFs. Online brokerage is certainly the cheapest and most popular option for everyday investors with brokerage being $10-$20 per trade. Keep in mind that brokerage fees will increase depending on the size of your investment and the broker you’ve chosen.
If you want you know more about making an investment, check this out.
5. Is the currency Hedged or Unhedged?
With ETFs tracking international assets, you’ll need to know whether the ETF is hedged or unhedged against foreign currency fluctuations.
Un-hedged ETFs have full exposure to the impact of currency fluctuations in the Australian Dollar and are typically offered at a discount to currency hedged ETFs. Unhedged ETFs can damage your returns if the Aussie Dollar falls, but the opposite applies in the reverse scenario.
Hedged ETFs aim to reduce the impact of currency fluctuations on the ETF’s returns. The issuer does so by converting the underlying assets from the originating currency to their currency of choice. During this process, an exchange rate is determined at a specific price, meaning it won’t undergo any further currency fluctuations.
Which one is right for you?
This is entirely down to your preference, risk profile, and investing time horizon. It’s also worth considering the stability of the currency that you’re investing in. With that said, investors who choose to dollar cost average over the long term will see that any currency fluctuations usually come out in the wash over time as long as the currency remains relatively stable. Check out this article if you want to dig deeper into currency hedging.
6. Net Asset Value
When selling a used bicycle, it’s rare you’ll find anyone who will willingly accept your listed price. Instead, you’ll go down a path of negotiations until you’ve both arrived at a mutual agreement of fair value. This can be a difficult process for a used bicycle. Fortunately, it’s very simple in the world of ETFs.
ETF’s have what’s called a Net Asset Value or NAV, which represents the value of the ETF’s underlying assets. The NAV can be employed as an indicator of an ETF’s ‘fair value’ (so you don’t need to work it out). Often investors use the NAV to determine good entry and exit points in and out of an ETF. You can utilize the NAV to your advantage by investing in an ETF trading at a discount to it’s NAV. Keep in mind that most issuers track and update their NAV in real-time so opportunities to invest below NAV will likely be few and far between. This is mainly due to the open-ended structure of ETFs, which means they can create more units should their demand rise, eliminating and supply and demand issues.
To ascertain if an ETF is right for you, it’s worth having a read through the fine print found on the ETFs Product Disclosure Statement (PDS). That’s where you’ll find all of the juicy information like the risks associated with a particular product.
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Disclaimer: This website (the “The Money Pal”) is published and provided for informational and entertainment purposes only. The information in the Blog constitutes the Content Creator’s own opinions and it should not be regarded as financial advice.