Exchange-traded funds are currently booming, with more and more investors allocating part of their resources to this innovative category of financial products. Every day, new ETFs of all kinds and characterized by the most peculiar features are listed on the world’s major stock exchanges. For those not entirely familiar with the concept of ETFs it might be worth, before reading this article, to have a look at this interesting guide summing up the main features of this category of financial products. In this article we’ll answer the question; What factors to look at when buying an ETF?
Psst: need a quick reminder on what ETFs are? Read this article before we’ll let you discover what to look for when buying an ETF!
In recent years, the number of ETFs has grown exponentially on a global basis, and all indicators suggest that this trend will likely continue in the future.
However, in light of this fast-growing offer, there are just as many investors who daily question themselves about what criteria to adopt when buying an ETF. Although ETFs are relatively simple products and suitable for investors of all types, one should still proceed with caution when selecting which ones to include in his/her portfolio. In this article, we will try to shed some light on this.
Before analysing each aspect in detail, here is an overview of the most important ones.
Asset Class
For an investor, it is very important as a first step to understand which asset class one wants to invest in. This depends primarily on one’s specific risk preferences, which play an important role.
Diversified and balanced investment portfolios have normally an exposure to different asset classes, in order to reduce risks without giving up on financial returns. How to build a resilient and low risk portfolio can be learnt with a few simple principles.
ETFs can mainly be grouped into equity, fixed-income or multi-asset. The former offer exposure to stocks, the second follow the performance of bonds, and the latter allow an investment into several asset classes in a single solution.
Equity ETFs can be grouped into the following categories, for example:
- Geographic: offer exposure to specific areas or countries of the world
- Real Estate: allow investments in the real estate sector
- Commodities: these ETFs replicate the performance of companies involved in the extraction and processing of raw materials
- Thematic: they have developed greatly in recent years and they track particular trends or investment themes
Bond ETFs mainly belong to the following three groups:
- Corporate bonds: these ETFs invest in bonds issued by companies, with a choice of various ratings and therefore risk levels
- Government bonds: they invest in bonds issued by sovereign states
- Emerging bonds: they track emerging market bonds, normally offering both higher returns but also higher risks
Multi-asset ETFs invest simultaneously in different asset classes, thus representing a one-stop-shop for diversified investment portfolios.
In Europe, the value of the ETF sector currently amounts to just over $1.2 trillion¹, of which the majority are equity ETFs. They are followed by bonds and those focused on commodities.
¹Data from Bloomberg Intelligence
TER
With the expression “TER” we refer to the ‘total expense ratio’, i.e. the annual cost that an investor faces when investing in an ETF. This figure is paid to the ETF issuer and serves as remuneration for operating the fund. The TER should therefore be viewed as the portion of the investment that is deducted each year in the form of expenses. It is important to note that this percentage is not calculated on the initial investment but on its value over time.
Normally, on average, costs range from around 15-20 basis points for the cheapest ETFs up to 70-80 for the most expensive ones¹. In addition to the TER, investors should inquire about the extent of any additional costs, such as those imposed by brokers for the execution of buy orders.
ETF Distribution Policy
Another element to pay attention to is the ETF’s distribution policy. ETFs are defined as distributing or accumulating depending on whether dividends are paid out to investors or not.
Investors seeking a regular income from dividends may choose to opt for the former in order to receive regular payments. In the second case, they are automatically reinvested and will allow investors to receive new shares without any new cash exbursement.
For those investors willing to learn more on the topic of dividends additional information can be found on this page: Dividends: Participation in Profits | VanEck
Replication Method
An often overlooked element, which can have important consequences, is the method of replication of the ETF. An ETF can be physically or synthetically replicated depending on whether or not the underlying securities are purchased.
In the first case, with full physical replication, the fund effectively owns all the securities contained in the underlying index it is tracking.
Where an ETF is synthetically replicated, it may track the value of the underlying stocks through the use of derivative contracts such as swaps. In this case, investors are exposed to greater risks; derivative contracts such as swaps involve third parties, giving rise to the so-called counterparty risk. These risks are accentuated in times of stress in the financial markets and the economy in general.
Synthetical replication represents only one of the risks of ETFs. It is of fundamental importance to be aware of them. More information here: Top 5 ETF risks | VanEck
Size and age of the fund
Although not extremely relevant, it can still be useful to analyse the size of the fund in terms of assets under management as well as how long it has been active. These two indicators can in fact provide insightful information in order to understand the degree of success of the fund’s investment strategy. Currently, the largest ETFs, which often replicate the most popular indices or broad segments of the global stock market, have assets under management worth well over USD 100 billion¹.
¹As an example, there are several ETFs tracking the S&P 500 index that have more than $100 bn in AUM.
SFDR Classification
Recently, more and more investors are paying attention to the sustainability level of their investments. The recent European Sustainable Finance Disclosure Regulation (SDFR)¹ obliges fund managers and other financial market participants to publish extensive ESG data on the investment strategies they offer.
There are three possible classifications ETFs can receive based on their level of sustainability and integration of ESG filters:
- Article 6: Funds without any policy or objective in terms of sustainability
- Article 8: Funds that promote environmental or social characteristics
- Article 9: Funds with an explicit objective of sustainable investments
Below is the evolution of the number of ETFs classified according to the three articles of the SFDR, from April 2021 to March 2022.
¹The SFDR came into force in 2021 and obliges several market participants to clarify the sustainability level of their investment strategies. The goal is thus to achieve transparency and provide investors with all the tools to make informed decisions.
It is clear, therefore, that investors for whom the ESG profile of their investment plays an important role may predominantly gravitate towards Article 8 or 9 funds.
