Exchange-traded funds, or ETFs, are rising in popularity. According to ETF.com, assets under management by US ETFs crossed the US$4 trillion mark earlier this year. That’s huge, to say the least.
It’s not hard to see why the investment vehicle is appealing. You can get wide diversification instantly with most ETFs. Expense ratios are typically low as well, enabling you to keep most of the returns generated.
But not all ETFs are the same. Before you invest in any ETF, you may want to take note of these eight key points.
1. What is an ETF
An ETF is a fund that is traded on a stock exchange, and it can be bought and sold just like any other stock on a stock exchange. An ETF can invest in all kinds of shares depending on the purpose of the fund, and there are many ETFs that aim to track the performance of a stock market index.
Singapore’s main stock market index is the Straits Times Index. There are two ETFs that track its performance, namely, the SPDR Straits Times Index ETF, and the Nikko AM Singapore STI ETF.
2. Mind the gap
The gap between a positive macro-economic trend and stock price returns can be a mile wide.
For example, gold was worth A$620 per ounce at the end of September 2005 and the price climbed by 10% annually for nearly 10 years to reach A$1,550 per ounce on 15 September 2015. But an index of gold mining stocks in Australia’s market, the S&P / ASX All Ordinaries Gold Index, fell by 4% per year from 3,372 points to 2,245 in the same timeframe.
In another example, you can refer to the chart below on the disparity between the stock market returns and economic growth for China and Mexico from 1992 to 2013. Despite stunning 15% annual GDP growth in that period for China, Chinese stocks actually fell by 2% per year. Mexico on the other hand, saw its stocks gain 18% annually, despite its economy growing at a pedestrian rate of just 2% per year.
So when finding themes to invest in via ETFs, make sure that the macro-economic theme you’re betting on can translate into commensurate stock market gains.
3. Replication method
ETFs can mimic the performance of a stock market index through two broad ways: Synthetic replication, or direct replication.
Synthetic replication involves the use of derivatives without directly investing in the underlying assets. It is the less ideal way to build an index-tracking ETF, in my view, because there is more complexity involved and hence a higher risk that a large proportion of the underlying index’s performance can’t be captured.
Direct replication has two sub-categories: (a) Representative sampling, where the ETF holds only a sample of the stocks within an index; and (b) full replication, which involves an ETF buying the same stocks in nearly identical proportions as the weights of all the stocks that make up an index.
You should try to invest in ETFs that use full replication if possible.
4. Reputation matters
Look for an ETF that is managed by a reputable fund management company. Vanguard, SPDR, iSHAREs, and Blackrock are just some examples of reputable ETF managers.
5. Track record
An ETF should ideally have a listing history of at least a few years, so that we can see how the ETF has actually done, instead of relying on the performance of the underlying index.
6. Watch your costs
The expense ratio (essentially all of the fees that you have to pay to the ETF’s manager and service providers) should be low. There’s no iron-clad rule on what “low” is, but I think anything less than 0.3% for the expense ratio deserves a thumbs-up.
Having a low expense ratio puts an ETF on the right side of the trend of investment dollars flowing toward low-cost index-tracking funds. This lowers the risk of an ETF’s manager closing the ETF down for commercial reasons.
7. The assets that are managed
An ETF’s assets under management (AUM) should be high – ideally more than US$1 billion. Having sizable AUM would also lower the chance that an ETF will close in the future. It’s not uncommon for ETFs to close. When a closure happens, it creates hassle on our part to find new ETFs to invest in.
8. Performance tracking
Lastly, you should look for a low tracking error. An ETF’s returns should closely match the returns of its underlying index. If the tracking error has been high in the past, there’s a higher chance that the ETF can’t adequately capture the performance of its underlying index in the future.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.