Intro to ETF Selection

There are well over 1000 ETPs listed on the London Stock Exchange, which ones are right for you?

With more than 900 ETPs listed on the London Stock Exchange and close to 5,000 available globally, choosing the right one can be tough. But as we’ll demonstrate below, it is also critical, because two ETPs that claim to promise the same exposure can actually deliver very different returns.

Exposure

By far the most important decision when choosing an ETF is selecting the kind of exposure you want. Even ETFs whose names suggest they track the same market in fact provide very different returns.

Here’s an example: The iShares FTSE China 25 ETF and the db X-trackers CSI 300 ETF both sound like they provide exposure to China, and they do. But they provide very different exposure to different share classes and liquidity pools within the broader Chinese market place.

So how do you find the right one for you?

Since most ETPs track indices, the most obvious place to start is with each ETF’s index. Look at the securities that comprise the benchmark, from their sector to their size to their country of domicile. Do they match the asset allocation you have in mind?

Once you know what securities are in the ETF, examine the methodology the index uses to select and weight its holdings. Some ETFs rely on passive, well-established indices, while others track newer, more innovative benchmarks whose constituents can change quite frequently.

Do the largest companies in the index get the largest weight (so-called market-cap weighting), like the FTSE 100 and the S&P 500? Does the ETF use an alternate approach, such as equal or fundamental indexing?

While it’s perhaps frustrating that you can’t stop your investment process with “I want to be in China”, the reality is the Chinese investment universe is not as easily defined as its geography.

(See our article, “Understanding Financial Indices” for more information.)

Expenses

After determining which ETF provides the exposure you’re really targeting, most investors rightly turn to the question of cost. Considering that a fund's expense ratio is the single greatest indicator of its future tracking difference, it's no surprise that low expense ratios are highly sought after.

The most critical cost to look at is the “total expense ratio”, which reflects the overall costs to manage and operate the fund. Bigger fees don't equate to better funds so looking to low-cost options may be a good first-step.  (For more, see our article Total Expense Ratio)

Tracking Difference

Expenses aren’t the only thing to worry about, however: You also have to think about how well the fund does its job.

While it seems like managing an index fund would be child’s play, in fact, there are good index managers and bad index managers. The way to separate the wheat from the chaff is to look at what investment pros call “tracking difference.”

Tracking difference is the difference between the return of an index and the return of a fund tracking that index over the course of a year. If the index was up 10% last year, was the fund up 10% as well? Or was it up 9%? Or 11%?

While you should be wary of funds that have underperformed their index, you should also beware of funds that outperform their index. As outperformance may be fleeting, consistency in tight index tracking is valued highly.

(For more, see our article Tracking Difference)

Currency

Currency exposure can impact your returns in multiple layers, and your choice of what currency to use can impact total returns.

For international ETFs, the fund’s underlying holdings may be in one currency, but the ETF’s net asset value might be calculated and priced in another currency. For example, an LSE-listed Japanese ETF might hold stocks priced in JPY but use USD as its base currency.

ETFs listed in the UK can be traded in different currencies. While the majority is traded in GBP, other options abound: There are also ETFs trading in USD or EUR.

So if you invest in an ETF traded in GBP but the fund itself has a base currency in USD, then the fluctuations between the two currencies can directly impact your total returns. (See Currency: The Basics.)

Risk/Structure, Reputation And Other Factors

Beyond tracking, exposure and costs, investors consider a variety of other factors when selecting ETFs. For some, structure is important and the difference between physically replicated and synthetic ETFs matters a great deal. For others, the reputation of the ETF issuer matters a lot. Still others worry about how likely it is a fund will close, or whether it makes use of financial derivatives.

None of these factors is make-or-break, in our opinion, but each investor is different, and these are valid topics to consider.

Liquidity

The topics listed above will help investors narrow their search from 1,300 ETFs down to one or two. But knowing which ETF you want to buy is just the first step; you also have to actually buy it!  

ETF spreads, market impact and other trading factors can cost as much or more than the ETF expense ratio itself.

We believe that ETF liquidity is so critical, in fact, that we’ve devoted an entire article to it.