How To Invest

10 key considerations before you invest in an ETF

In an era where financial markets offer a multitude of investment options, exchange-traded funds (ETFs) have emerged as a convenient option for investors seeking to grow their wealth without the complexities of hand-picking individual stocks. ETFs bundle stocks, bonds, or commodities into a single investment vehicle, providing unparalleled diversification across various sectors and global markets.

With over 7,000 ETFs available worldwide, the power of choice is at investors’ fingertips. The question naturally arises: Just like hand-picking stocks, how do you sift through this ocean of ETFs? How do you select the ‘superior’ ETFs from among their peers, even when they appear to invest in the same sector or industry? This article will explore ten key factors to consider before investing in an ETF.

1. Define your investment goals

Defining your investment goals is crucial for navigating the diverse world of ETFs. Whether you aspire to secure a steady income stream through dividend investments, harness the growth potential of high-growth companies, or strategically manage risk in volatile markets, will decide the kind of ETF you choose.

Tailoring your investments to align with your investment philosophy, assessing your risk tolerance, selecting specific geographic and sector focuses, and choosing your preferred investment style and strategy are all essential components of this journey. Your investment goals guide your decisions, helping you select the ETFs that best match your financial goals and temperament.

2. Analyse the underlying holdings

Within each ETF lies a diverse basket of underlying assets, which comprises securities such as stocks, bonds, commodities, and more. It’s vital to scrutinise the assets held within the ETF to ensure they match your investment goals and risk profile.  While some ETFs claim to focus on specific industries, regions, or market sectors, the actual constituents of their underlying holdings may deviate from your expectations.

For instance, consider an investor seeking exposure to the thriving Chinese tech equity market; they might turn to the CQQQ ETF. However, it’s essential to note that CQQQ does not include Alibaba among its holdings, and if you have a strong desire for Alibaba within your portfolio, this ETF falls short of your requirements. This discrepancy underscores the importance of meticulous research to ensure that the ETF actually caters to your objectives. To achieve this, a prudent practice is to navigate to the ETF’s official website and access its factsheet, particularly focusing on the top ten holdings. Analyse what these holdings constitute and their weight within the ETF, ensuring that this composition aligns with your investment goals and harmonises with your risk tolerance.

3. Physical vs. synthetic replication

When considering ETFs, it’s crucial to understand the underlying replication methods, broadly categorised into two main approaches: physical and synthetic replication.

For physical replication, an ETF will hold the tangible, real assets that comprise the index they aim to track. This approach is more straightforward and transparent, as investors directly own these assets through the ETF. However, physical replication often comes with higher fees due to the costs associated with buying and maintaining the assets.

On the other hand, synthetic replication is more commonly employed when acquiring the underlying assets proves challenging, such as in the fixed income and commodity markets. These ETFs employ derivatives and swaps to replicate the performance of the index. While synthetic replication can offer cost advantages and lower fees, it introduces risks, including tracking error and counterparty risk.

4. Tracking error

A lower tracking error signifies a close alignment between the ETF’s performance and the target index’s returns. Essentially, the fund is executing its mandate with a high degree of accuracy, mirroring the movements and changes in the underlying index. Investors often favor ETFs with minimal tracking error, as this characteristic enhances the confidence in the fund’s ability to deliver returns in line with the broader market or specific sector it intends to represent.

Conversely, a high tracking error raises flags for investors, as it may indicate potential inefficiencies in the fund’s management or the tracking process itself. Such deviations from the index’s performance can stem from a variety of sources, including transaction costs, management fees, and the fund’s replication methodology. In these instances, the ETF might not be faithfully capturing the movements of its benchmark, leading to a divergence in returns that investors may find undesirable.

Investors should view tracking error as more than just a statistical measure; it is a valuable tool for assessing the efficiency and reliability of an ETF as an investment vehicle. By carefully evaluating tracking errors, investors can gain insights into the fund’s ability to replicate its benchmark accurately and make more informed decisions about the suitability of the ETF within their overall investment strategy. In essence, a lower tracking error can be seen as an indicator of the ETF’s precision and effectiveness in delivering on its investment objectives, reinforcing its role as a dependable and consistent tool for investors navigating the complexities of the financial markets.

5. Fund size and liquidity

Fund size and liquidity are important factors in ETF investing. Larger ETFs offer a sense of security and sustainability. The profitability of the ETF provider is typically correlated with the size of the fund, reducing the likelihood of untimely closures and ensuing peace of mind for investors.

At the same time, larger ETFs usually have higher liquidity. This is often gauged by daily transaction volume, which impacts the ease of buying and selling an ETF. A more liquid ETF minimises the risk of price fluctuations and assures investors of a prompt exit when needed.

6. Dividend policy

ETFs come with two distinctive dividend policies: distribution or accumulation. ETFs with a distribution policy regularly disburse the dividends from their underlying assets to investors, serving as an income source.

In contrast, accumulation ETFs systematically reinvest the dividends from their underlying assets into the fund, enhancing returns over time (assuming the ETFs performs). It’s essential to align your choice with your financial objectives, whether you seek regular income or aim for long-term growth.

7. Currency risk

Consider the currency in which the ETF is traded. Investing in an ETF denominated in a foreign currency introduces currency risk, which can impact your returns. The volatility in exchange rates can either amplify or mitigate the gains/losses of the underlying assets held within the fund. If the foreign currency appreciates relative to your home currency, it can enhance returns. Conversely, a depreciation can erode the returns and potentially lead to losses, even if the underlying assets performed well in their local currency.

8. Expense ratio

The expense ratio represents the cost of managing an ETF. Lower expense ratios mean more of your investment is put to work, so choosing ETFs with competitive expense ratios is essential. Small differences in expense ratios can significantly impact your long-term returns. However, it’s crucial to maintain a holistic perspective when selecting an ETF. While a low expense ratio is compelling, it should be weighed alongside other factors discussed in this article to construct a well-informed investment decision that optimises cost-efficiency and alignment with your investment strategy.

9. Reputation of the ETF provider

Industry giants like Vanguard and iShares are known for their extensive track records and broad asset management expertise. A provider’s reputation can be a reliable indicator of the ETF’s quality. A provider with a sterling reputation is more likely to uphold rigorous standards of due diligence, transparency, and investor communication. This instills confidence in investors, assuring them that the ETF is managed by a team with a deep understanding of market dynamics and a commitment to aligning the fund’s performance with investor expectations.

10. Domicile and tax considerations

Be mindful of the tax implications of investing in an ETF. Depending on the fund’s domicile and your personal tax situation, you may be subject to withholding taxes on dividends or capital gains. It’s vital to gain clarity on the tax regulations and opt for tax-efficient ETFs that align with your financial strategy.

For instance, foreign investors seeking exposure to the S&P 500 index often favour Irish-domiciled ETFs (e.g., CSPX) over their U.S. counterparts (e.g., SPY) due to their lower dividend withholding tax and avoidance of U.S. estate tax. Ensuring tax efficiency safeguards your hard-earned earnings and maximises the potential of your ETF investments.

The fifth perspective

Investing in ETFs can be a potent strategy for diversifying your investment portfolio and working towards your financial objectives. However, the key to successful ETF investing lies in meticulous due diligence. By carefully considering and weighing these 10 critical factors, you can empower yourself to make informed investment decisions that align seamlessly with your goals and risk tolerance.

Wang Choon Leo, CFA

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that can connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term. Choon Leo is a CFA charterholder.

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