1. Minimise Transaction Costs
2. Check the spread (refer to this article How to Buy ETF’s article)
3. Minimise the purchase price surplus to Intraday Net Asset Value (refer to How to Buy ETF’s article)
4. For any given investment exposure avoid ETF’s with high fees (refer to this article for a List of Australian ETF’s on the ASX and their associated fees)
5. Buy ETFs with a good record of closely tracking their benchmark index
6. You may want to consider avoiding ETF’s that lend out their investments to 3rd parties (what’s in it for you?)
7. Unless their is no alternative you may want to consider avoiding ETF’s that track synthetically their benchmark index
8. The size of the ETF matters, you may want to consider avoiding very small ETF’s
ETF Transaction Costs
Trading costs add up for index investors that frequently rebalance their portfolios and diminishing them to as low a level as possible by selecting a low cost broker is highly desirable.
Every time you buy or sell an ETF share you pay commission, these transaction costs can be as or more significant than the total expense ratio. Many investors avoid thinking too much about trading costs, but in the long term they are a key driver of how much money you are going to make, arguably the key driver!
ETF Bid/Ask Spreads
ETF’s are traded on the stock exchange and there is spread between the bid and the ask price, ETF’s with a low volume have big spreads. This may mean you end up paying more than the underlying asset value to get hold of some stock. Average daily trading volume tells you a lot (Google, Yahoo etc list volume next to historical prices). In general, high-volume correlates with low spreads, though exceptions are not unusual.
Look at spreads as a percentage of share prices, not cents; this makes for more meaningful comparisons, whether the funds you’re looking at are worth $100 or $20 a share. For how to calculate this amount refer to this article Investors Portfolio Total ETF Cost.
Discount or Premium to the Intraday Net Asset Value
The intraday net asset value is the estimated value of the underlying portfolio and is available from most ETF providers websites. If the ETF’s underlying portfolio is illiquid it is possible for a significant premium or discount to arise between the intraday asset value and the price the ETF is trading for on the stock exchange. Refer to this article How to Buy ETFs for more information on the intraday net asset value.
Avoiding funds with high expense ratios sounds like a cinch, but it’s not.Within Australia operating expense ratio’s vary significantly from 0.06% to 1.19% (refer to current ETF’s listed on the ASX)
The international field is even more diverse. A 0.50% is expensive for U.S. large-caps, but cheap for an emerging market debt portfolio. European traded ETF’s are more expensive than ETF’s traded in the US. It is a far costlier endeavour to run ETFs in Europe due to multiple exchanges, currencies, languages, taxes, settlement systems, regulatory requirements to register and cross-list and sales teams spread across more than one country.
In short you need to define the group of funds you’re interested in then compare the fees.
But beware this isn’t always easy!
Headline fees on a fund’s fact sheet aren’t always reflective of all-in fees. For example many Index providers typically ignore the costs of rebalancing when calculating their benchmarks’ return. Also a hedge fund ETF may have a total expense ratio (TER) of 90bps. But in addition, the underlying hedge funds charge a 200bps annual fee as well as a 2000bps performance fee. On top of this the issuer charges an additional 50bps for risk monitoring and a 15bps index fees as well as a custody fee of 8 bps and a swap charge of 23bps.
It’s worth digging through the prospectus to unearth all the charges associated with a particular product. TERs can be just the tip of a very big iceberg.
ETFs usually deliver fairly precise exposure to the indexes they track, but check the tracking error. Also what’s in the index? Even the most famous indexes—the Dow Jones industrial average, the S’P 500 and the Nasdaq 100—provide very different exposures.
Do you actually understand the index and how it is being tracked? Smart investors know what the fund owns and why.
Other factors that investors need to be aware of include the impact of securities lending in physical ETFs. These activities generate revenues which can help to reduce the negative impact of costs like TER on a fund’s performance, but there can be counterparty risk involved. This is very hard risk for investors to measure up until its too late, what’s in it for you the investor if the fund lends its securities?
If you are in the market for pure exposure to some assets, ETF’s used futures or swaps to access them. Buried within the transaction swap spreads in synthetic (derivatives-based) fund are costing you money. And they can also be heavily exposed to counterparty risk. Think of these ones as short term trading vehicles.
Size of the ETF
Very small asset ETF’s are also worth watching out for bases, because that can signal poor tradability and fund closure risk. In general, the more assets and the older the fund, the better. Its worth getting a handle on whether money is flowing into or out of the fund there are free tools available.