From small beginnings in the early 90s, exchange-traded funds (ETFs) have become the smartphones of the investing world. Investors across the globe have lapped up these simple-to-use creations, which are basically investment funds or baskets of securities listed on a stock exchange. Amazingly, the growth rate in ETFs has out-paced technology adoption growth rates in social media and retail ecommerce in the US.
With the astonishing growth of ETFs, an extraordinary range of products have been developed. There’s now an ETF for almost everything – markets, sectors, countries, geographies, commodities, geared shares and short strategies. We even have ETFs for the space industry, video gaming, pet care, anti-social vices, religion, weed and veganism. Yip. That’s weird alright.
Since there’s so much choice, it’s essential to know how to choose an ETF. In this post, the following key considerations are covered for Kiwis looking at ETFs. This is intended as a guide for investors starting out their journey investing overseas. It is not personal financial advice.
- Investment approach
- Bid/Ask spreads
- Strategy fit
Before you invest, it’s important that you’re comfortable with the provider behind the ETF. You are investing in their capabilities, not a crusty steak and cheese pie from a servo or a fancy coffee machine from Harvey Normal (sorry, Norman).
Ask yourself the following: is the provider a brand you know? How long have they been around? What are their assets under management? Who’s managing the ETF? When you ask these questions, they should provide some assurance about the brand and people behind it.
It’s a good idea not to limit your research just to the provider’s website, and perfectly sensible to use the fabulous Google machine to check for relevant news. You might sometimes discover things important to your decision.
A great example of this is the issues of race and gender diversity with the ETF from State Street – the SHE ETF.
Two years ago, State Street was fined USD 5 million by the Trump administration for paying women and African Americans less than men – an action that conflicts with the message of their product. To make a bad situation worse, Morningstar research has shown that State Street’s voting record doesn’t reflect the investment objective outlined in the prospectus. They not only failed to support any of the five equal pay resolutions that came up for a vote over a three-year period, but also didn’t support 81% of the gender resolutions in total.
Understanding the investing approach of any ETF is key. Thankfully, a finance degree isn’t required to understand many ETFs. When you start looking at an ETF, you should think about whether you can understand the ETF and what it’s trying to do. It’s useful to look at the holdings in relation to the objective of the ETF, which should help you understand a lot about it. If you still can’t understand their approach after looking at it for a while, it might an idea to ask yourself should I invest in it?
One ETF myth is that they’re all cheaper than chips. However, ETF fees vary greatly – it all depends on the strategy and objective of the ETF. For example, some actively managed or specialist ETFs like the Ark Innovation ETF charge 1.00% pa, while other more generalist ETFS like the Vanguard S&P 500 ETF charge 0.03% pa.
A common mistake is to believe that because something is cheap, it’s good. It’s important to look at fees on a relative basis. Here’s a couple of tips.
First, ask yourself this: are potential returns from the ETF going to justify the costs? You need to be comfortable that you’ll be compensated for the fees you pay, even though they may appear to be low. It makes no sense paying fees if you don’t believe the ETF will provide worthwhile returns.
Second, it’s a great idea to compare the costs of similar, alternative ETFs if you’ve found one or more that interest you. There’s some great databases for this, including the ETF screeners from ETFdb.com and ETF.com.
A bid/ask spread is the difference between the highest price that someone is willing to pay (bid) and the lowest price that someone is willing to sell (ask). For ETFs, these matter. The issue isn’t so much with large, heavily traded ETFs where spread is small. It’s more with the smaller ETFs that invest in less liquid assets like small caps. Here the spread can be larger, which can increase the costs of buying or selling them. There are a couple of approaches investors use to control prices. First, there’s limit orders. A limit order is when you buy or sell a share at a set price or better. Secondly, there’s the timing of when trades are executed. Buying or selling at opening and closing can be detrimental. At these times, volatility can be higher and bid/ask spreads wider.
Size does matter! An ETF with low assets under management say, for example, $15 million or less has a stronger chance of closing than one that’s $500 million in assets. Investing in an ETF that closes means you have to find another, which may be a hassle. On the subject of size, don’t assume that just because an ETF has a low average trading volume it is a dog with fleas. The liquidity of an ETF is shaped primarily by what the ETF invests in.
This one is a killer. It’s important that you know how the ETF fits within investment strategy. Is it a core holding? A small part of your portfolio that reflects an interest you have like technology or health care? What? There’s no point investing in something if you don’t have a strategy to begin with.
In a world where there’s an ETF for everything, it’s important to have criteria for evaluating an ETF you are interested in. If you are unsure, you should seek advice from an Authorised Financial Adviser.
Finally, you will notice I’ve excluded performance. That’s a separate topic to be addressed at later day, which has wider implications for investing than just ETFs. Evaluating investment performance is somewhat of a hornet’s nest.
The above is my opinion. It is not intended to act as personal financial advice. It does not take into you account your financial objectives, situation and needs. It is strongly recommended you seek financial advice from an Authorised Financial Adviser before you make a decision.