ETFs are undoubtedly one of the biggest financial innovations of the last few decades. In this piece, we will show what an ETF is, why we use them in our Portfolios and how we are trying to select the right ones.
An ETF (exchange-traded fund) is a fund, whose objective is to track the return of a chosen index, such as S&P 500, as closely as possible rather than trying to beat it. They provide exposure to a wide pool of financial instruments, like all companies within S&P 500, without having to buy them individually and are significantly less expensive than mutual funds. Also, ETFs offer far greater liquidity than mutual funds, as they are actively traded on the stock exchange.
Why do we use ETFs in our Portfolios?
We use ETFs exclusively, due to three major factors – diversification, low costs and liquidity. ETFs, enable us to invest in and gain exposure to a wide range of securities, say US stocks, emerging markets or European government bonds with a single transaction, thus allowing us to easily build diversified portfolios and to significantly limit trading costs.
Additional to small trading costs, ETFs charge only a fraction of what traditional mutual funds do and unlike those funds can be traded whenever a stock exchange is open.
How do we choose ETFs?
Usually, there are many ETFs, which track the same index or provide exposure to a specific country, sector or theme and choosing the right one is not an easy task. We use quantitative and qualitative criteria to choose among over 2000 ETFs to ensure that we find the right one. Here is a list of elements we consider prior to making a decision.
- What is it made of? - Components
The first thing we consider when choosing an appropriate ETF is what’s inside. ETFs disclose the securities they hold on a daily basis, so we can easily compare several ETFs which provide exposure to, say, European stocks and decide whether some of them have securities that we particularly like or dislike.
- Accuracy is the key – Tracking error
Tracking error is an indicator which measures the accuracy of tracking the performance of the underlying index. Tracking error depends mainly on the replication method utilized by an ETF. We prefer ETFs which exhibit less deviation from the index performance.
- Make sure it’s tradeable – Size and liquidity
We take into consideration both the size and the liquidity of each ETF. We prefer bigger ones, as we do not want to hold a relatively big “chunk” of any ETF. Higher liquidity means lower bid-ask spreads and a smaller impact that the transactions we make will have on the price. We also consider the liquidity of the underlying securities, which may pose a risk during the market downturn.
- Value for money – Currency
ETFs are traded in many currencies around the world and the securities they hold may also be traded in various currencies. We usually invest in ETFs, where both the trading currency and the currency of underlying securities matches the currency of our Portfolio. In some circumstances, when we think it to be advantageous we may invest in a ”hedged” version of an ETF.
- How is it made? – Risk
The risk is one of the major factors which affects our decisions and the investment process in many ways. Some ETFs are simply riskier due to index they track (think of emerging market stocks vs. US Treasury Bonds), others are riskier due to their replication method. Physical ETFs invest in all, or a representative sample of securities which constitute the benchmark index, which makes them less risky, but a bit more expensive and more exposed to tracking error risk. On the other hand, synthetic ETFs enter into an agreement with an investment bank, which provides the required return, thus limiting costs and tracking error, however exposing the ETF to counterparty risk. We have to carefully balance those risks when we choose ETFs.
- A penny saved is a penny earned - Low Costs
All things considered, we choose ETFs which have the lowest Total Expense Ratio (TER) and other costs (bid-ask spread, taxes etc.).
The bottom line
It’s not in question that ETFs provide a low-cost tool for diversified investments and have changed the financial industry permanently. Still, with such a fine selection of ETFs to choose from and their growing complexity one must take multiple factors into consideration before making an investment decision.