How to choose an ETF

Not all exchange-traded products are created equal. Here’s what to look for.

Summary: Investors choosing between similar exchange-traded funds offered by different providers should look at the size and reputation of the provider and check the exact exposure offered by the ETF. It’s also worth considering the total cost, including management fee, brokerage fees and the buy-sell spread. Among Australian-listed ETFs, there is generally plenty of liquidity for retail investors – but if you are interested in one of the more obscure products, then liquidity is a consideration.

Key take out: Don’t just pick the cheapest ETF – cost is important, but first make sure it’s the right product for you.

Key beneficiaries: General investors. Category: Shares.

The amount of money flowing into exchange-traded funds has increased steadily in Australia since their local launch less than 15 years ago, accelerating after the Future of Financial Advice reforms banned financial planners from receiving commissions on products in 2013. Some of the largest providers operating in Australia include BlackRock’s iShares, Vanguard, BetaShares, Russell and State Street. ANZ also recently announced that it would launch an ETF service. ETFs allow an investor to buy a basket of shares in one trade, and funds are available that track Australian large-cap and small cap indices, as well as indices all over the world. A number of newer products offer exposure to currencies, commodities and even the ability to bet on a market downturn.

Investors who decide to purchase, for example, an ETF covering large-cap US stocks will find a wide range of choices from different providers that at first glance might appear more or less the same. But on further inspection each product can be quite different, and these differences can affect your investment returns.

Here’s what to look for when choosing an ETF.

Examine the issuer

Both buyers and sellers of ETFs recommend considering the size and reputation of the provider. Consider whether it’s a large provider with a commitment to the Australian market and a history in offering ETFs, as well as a broad range of products to choose from. Giselle Roux, chief investment officer at Escala Partners, says the more well-known providers “give a greater sense of comfort” to investors, particularly to investors who have less experience in using ETFs. She adds that large providers are more likely to be able to offer products for a low cost.

Experts agree that the issue of smaller, less reputable providers is less of an issue for Australian-listed products, but warn that it has been an issue for ETFs listed elsewhere around the world. As the ETF sector continues to expand in Australia over time, it could be worthwhile keeping an eye out for the entrance of any providers that appear questionable.

Check the exposure

To compare similar ETFs, take note of the exact name of the index. Some providers will track an index compiled by FTSE, some by MSCI or some by S&P. Although one isn’t necessarily better than another, it’s always worth knowing what you’re buying before making a purchase. Roux says that in emerging markets, the differences in indices can be “miles apart” – stocks can be weighted differently, or different stocks can be included.

All ETF providers in Australia provide “very decent” online summaries of a few pages in length that cover what the constituents of the ETF are, what the fees are and other details, Roux says. She encourages investors not to buy an ETF without looking at the providers’ websites and reading the summary on offer for each product they are considering, to get a sense of any differences.

She is keen to ensure investors understand the new “smart beta” ETFs, which track the stocks in an index but weight them according to fundamentals, volatility or equal weighting, rather than by market capitalisation (see Everything you need to know about “smart beta”, April 1). “I’m not against their use. I’m just saying people should not assume they’re following a benchmark – this is constructed by the underlying provider,” she says. “In many cases the index they follow is not an index, it’s a quantitative screen of companies given certain characteristics.”

BlackRock and BetaShares publish a full list of holdings for each of their ASX-listed products on their websites every day, so that investors can see exactly what is inside the ETF. Vanguard also publishes full lists of holdings, but prefers to release a list of holdings dated at the end of each month with a 10-day lag, to avoid other large investors trying to front-run their strategy of rebalancing to keep up with changes in the index.  

So for a private investor to protect themselves here, the smartest thing to do is to check if the structure of the ETF is physical or synthetic: Does it actually hold the underlying assets, or does it hold derivative products such as futures instead? This is particularly relevant for commodities ETFs – many gold ETFs on the ASX are physically backed, but a range of other synthetic products are also available. For example, BetaShares offers synthetic ETFs covering crude oil, agriculture and a basket of commodities.

A list of all the exchange-traded products on the Australian Securities Exchange, including links to the ETF providers’ websites, is available here.

Calculate the total cost

The cost to an investor of an ETF has multiple components. ETFs charge a set management fee, which is often lower than the fees for actively managed funds, as the provider is not researching and selecting specific stocks. For baskets of large cap US stocks, fees of 0.1 per cent or less are on offer, while fees for Australian equities ETFs generally range from 0.2 per cent to 0.4 per cent. Funds covering commodities and emerging markets often charge around 0.7 per cent.

Another component of the cost is the buy-sell spread, or the difference between the price buyers are offering for a product and the price at which sellers are prepared to sell. Wider spreads increase the total cost to investors.

Investors also pay brokerage fees each time they trade an ETF.

Jonathan Howie, head of BlackRock’s iShares Australia, warns investors not to buy an ETF primarily based on its cost. “First people need to make sure it’s the right exposure and meets their investment need,” he says. Traders who plan to buy and sell more frequently generally need to be a little more concerned with brokerage and spreads, while investors who plan to hold an ETF for the long term will usually need to focus more on management fees, he says.

The gap between the performance of the underlying index and the performance of the ETF is known as tracking difference. On an ETF provider’s website, look for a table labelled “returns” or something of a similar description that compares the returns of the ETF and the index over a number of time periods such as the past year, three years, five years, etc. If an ETF tracks its index closely, the gap should be the same size as the management fee charged.

Figure 1. Illustration of two ETFs that vary in tracking difference

Source: BlackRock

For example, the iShares Core S&P 500 ETF (ASX code: IVV) has a management fee of 0.07 per cent. The gap between the performance of the fund and its index was 0.08 per cent over the past year, 0.07 per cent over the past three years, 0.1 per cent over the past five years, 0.06 per cent over 10 years and 0.07 per cent since inception.

Figure 2. Tracking difference for IVV

Source: BlackRock

Look at two levels of liquidity

Investors can see how often an individual exchange-traded product is traded by searching for the product on the ASX website and looking at the product’s volume.

But this is only one element of ETF liquidity: Experts say it is more important to understand the liquidity of the underlying market where the ETF is buying securities. If demand for an ETF in a liquid market rises, the ETF manager is able to buy more securities and increase the number of units in the fund to meet demand.

In less liquid markets, there are fewer buyers and sellers, so the gap between the price one investor is prepared to pay for an asset and the price at which another will sell can be wider.  

Vanguard’s head of investments Rodney Comegys says that for most of the top Australian-listed ETFs, there is plenty of liquidity for retail investors to make the trades they want. He says it would only be for a product trading very few shares a day, such as some of the smaller global ETFs, where a private investor placing an order size of $10,000 or above might find themselves making a large trade and have to consider how best to execute it.

If you are dealing with one of the more obscure ETFs then Comegys recommends investors always use a limit order to avoid the price moving too much. Investors placing a large order can also contact the provider’s capital markets team for assistance. “And if there’s not enough liquidity there to get what you need done, look for an alternative product,” Comegys says.

Check the time of day

When buying ASX-listed ETFs that invest in offshore assets, the underlying markets may not be open during ASX trading hours. “When the ASX opens at 10am, Europe’s asleep,” points out BetaShares managing director Alex Vynokur. This example does not pose a problem to Australian investors; Vynokur explains that a liquid European futures market operates during Australian market hours.

But BetaShares offers a number of commodity funds that track indices based on futures that trade on the Chicago Mercantile Exchange. During the Australian summer, this market opens at 11am Sydney time, and BetaShares issues announcements to the ASX reminding investors of the time difference. “[During this season] we encourage investors to only consider buying and selling after 11am Sydney time, that’s when the underlying markets are open,” Vynokur says. “When the underlying markets are open, there’s a better mechanism of price discovery.”

As with other listed securities, price discovery for ETFs generally is best once the whole market is open, given it opens alphabetically over about 10 minutes from 10am.

Remember to diversify

Vanguard’s Comegys cautions investors against choosing a large cap ETF from one index provider and a small cap ETF for the same market from another index provider, particularly for US or Australian stocks. If the different indices are calculated slightly differently, an investor might end up with overlap between the bottom “large caps” from one and the top “small caps” from another. Alternatively, there might be a gap, with some stocks missing from both. On the other hand, he says it would be fine to pick an Australian ETF based on the S&P/ASX200 index and then a FTSE or MSCI index that covers the rest of the globe.

Comegys encourages investors to look for ETFs that offer diversification, particularly to SMSF investors who are overweight Australian large-cap shares. Some ETFs will hold a broader range of stocks than others.

Conclusion

Even though there are many factors to consider when choosing an ETF, iShares’ Howie says the three key points are the size of the issuer, the structure of the fund and the range that an issuer offers. “If an investor focuses on those, they will do very well.”

The amount of funds that Australian investors hold in ETFs is likely to continue to increase. As with any investment decision, it’s worth knowing your product before making the trade.