So you’ve heard that an easy and cost-effective way to invest is through an ETF. But how do you do that? How can you possibly choose from the thousands of ETFs available on the global market? In this article, we’ll look at the different attributes you should consider when choosing an ETF. By the end of this, you should be able to understand which ETFs are suitable for your financial situation and location.
The information provided in this article is for educational purposes only and should not be considered as financial advice.
What is an Exchange-Traded Fund (ETF)?
First things first, what’s a fund? A fund is simply a pool of money collected for the purpose of investing in a particular financial asset (e.g., a group of shares in a company). Funds allow you to pool your money with other investors to invest in the asset. This is useful when the asset you want to buy might be too expensive to do so individually. A fund is typically managed by an individual (fund manager) or a company (e.g., Vanguard).
You’ve probably heard the term “index fund.” An index fund is a fund that follows a particular index. So what’s an index? An index is a snapshot of a specific segment of the market. For example, I can have an index fund that tracks the 500 largest companies in the US (the S&P 500). You can have all kinds of indexes, e.g., renewable energy sector, transport, European, small companies, etc. Index funds are popular for a few reasons, the main one being that they do not require active management. A segment is set at their creation, and they simply track that segment. This means lower costs for the consumer.
So, finally, what is an exchange-traded fund? An ETF is just a fund available for trading on an exchange (e.g., NASDAQ, London Stock Exchange, or Frankfurt Stock Exchange). This means you can buy and sell it like a stock during market hours. While most ETFs are index funds, not all of them are. When people say you should invest in an ETF, they usually mean an index ETF.
Why Index ETFs?
Index ETFs have several desirable qualities. They
- allow us to get a share of many different companies in different industries and geographies. This follows the “Don’t put all your eggs in one basket.” strategy a.k.a diversification.
- are low cost compared to actively managed funds.
- are flexible in how and when we can sell them.
- allow us to invest in entire markets or sectors easily.
What are the things we should consider when choosing an ETF?
This is where people tend to get overwhelmed. There are a few things you want to look at when choosing an ETF.
Let’s dive into those attributes and explore what they mean for your ETF investment. We’ll keep it simple and give you some typical values to look out for.
Expense Ratio
The percentage of your money that goes to running the fund each year. This is the yearly cost of owning the fund.
Typical values:
- Low: 0.03% - 0.10% (usually for broad market index ETFs)
- Average: 0.20% - 0.50%
- High: Above 0.75% (often for specialized or actively managed ETFs)
Tip: Aim for the lowest cost possible, especially for long-term investments. Even small differences add up over time!
What the ETF Invests In (Underlying Index and Stock Weighting)
This tells you what the ETF is buying and how it decides how much to buy of each thing. The specific part of the market the ETF follows and how it chooses how much to invest in each company.
Common ways of deciding:
- Based on company size (most common)
- Equal amounts in each company
- Based on company health measures
Tip: Choose a market area that fits your goals. Broad market ETFs are great for beginners, while specific industry ETFs might suit more targeted plans.
Total Fund Size (Assets Under Management)
This is the total value of all the investments the ETF owns. The total market value of everything the ETF controls.
Typical values:
- Small: Under $100 million
- Medium: $100 million - $1 billion
- Large: Over $1 billion
Tip: Bigger funds often mean it’s easier to buy and sell shares, and there’s less chance of the fund closing. But don’t ignore smaller ETFs if they fit your needs.
Fund Company (Fund Issuer)
This is the company that created and runs the ETF. The financial company responsible for the ETF’s creation and management.
- Major companies: Vanguard, BlackRock (iShares), State Street (SPDR), Invesco, Charles Schwab
Tip: Look for well-known companies with a history of good management. Bigger isn’t always better, but it can be reassuring.
Trading Volume
This is how many shares are bought and sold each day i.e. average number of ETF shares traded daily.
Typical values:
- Low: Less than 100,000 shares per day
- Medium: 100,000 - 1 million shares per day
- High: Over 1 million shares per day
Tips: More trading usually means it’s easier to buy and sell. But don’t rule out less-traded ETFs if they fit your goals.
Dividend
Some ETFs give regular cash payments to investors. These are cash payments that companies decide to give to their investors (you!).
- Types:
- Distributing (Paying out): Gives cash to investors
- Accumulating (Reinvesting): Puts the cash back into the fund
Tips: Think about whether you need regular cash payments and how it affects your taxes when choosing.
Past Performance
This shows how the ETF has done over time. How much money the ETF has made or lost in the past, usually compared to the market it follows.
- Usually shown for: 1 year, 3 years, 5 years, and 10 years (if available)
Tips: Remember, good past performance doesn’t guarantee future success, but it can show how the ETF has handled different market situations.
Currency (Denomination)
This is the money type used for the ETF.
- Definition: The type of money used to buy, sell, and value the ETF shares.
- Common types: US Dollars, Euros, British Pounds, etc.
Tips:
- Think about exchange rate risk if buying ETFs in a different currency than your own. Some ETFs offer versions that protect against currency changes.
- Big ETFs often come in different currencies to match where you live.
A Note on Taxes
Taxes on ETFs are typically classified under capital gains tax.
- Things that matter: How often you buys and sell an investment, how it handles dividends
Tips: Become familiar with the tax laws around ETFs in your country.
Remember, no single ETF will be perfect in all these categories. The key is to find one that balances these factors in a way that aligns with your personal investment goals, risk tolerance, and financial situation.
Example Analysis & Comparison of Two Popular ETFs
Now that we’re familiar with the key terms, let’s put our knowledge into practice by comparing two widely-held Vanguard ETFs: Vanguard FTSE All-World UCITS ETF Accumulating and Vanguard S&P 500 UCITS ETF Distributing. Remember, ETF details can change over time, so always double-check the most current information before making investment decisions.
Vanguard FTSE All-World UCITS ETF Accumulating (VWCE)
- Expense Ratio: 0.22% (as of Oct. 2024)
- Underlying Index: FTSE All-World Index
- Assets Under Management: €13.5 billion (as of Oct. 2024)
- Fund Issuer: Vanguard
- Dividend Policy: Accumulating (reinvests dividends)
- Currency Denomination: Depends on the ticker, e.g. VWRP, VWCE, VWRPA. Check the ETF fact sheet.
VWCE aims to track the performance of the FTSE All-World Index, providing exposure to both developed and emerging markets worldwide. It’s a good choice for investors looking for broad global diversification in a single fund.
Vanguard S&P 500 UCITS ETF Distributing (VUSA)
- Expense Ratio: 0.07% (as of Oct. 2024)
- Underlying Index: S&P 500 Index
- Assets Under Management: €39.8 billion (as of Oct. 2024)
- Fund Issuer: Vanguard
- Dividend Policy: Distributing (pays out dividends)
- Currency Denomination: Depends on the ticker, e.g. VUSA.S, VUSA.DE etc. Check the ETF fact sheet.
VUSA tracks the S&P 500 Index, which represents 500 of the largest U.S. companies. It’s popular among investors seeking exposure to the U.S. stock market.
Comparison
Expense Ratio: VUSA has a lower expense ratio (0.07% vs 0.22%), which could lead to better long-term performance, all else being equal.
Underlying Index: VWCE offers global diversification, while VUSA focuses solely on large U.S. companies. Your choice depends on your desired geographical exposure.
Assets Under Management: Both are well-established with significant AUM, indicating good liquidity and low risk of fund closure.
Dividend Policy: VWCE reinvests dividends, which can be tax-efficient and good for long-term growth. VUSA distributes dividends, which might suit investors seeking regular income.
Currency Denomination: VWCE is in EUR, while VUSA is in USD. Consider your local currency and potential currency risk.
Historical Performance (as of Oct. 2024):
- VWCE: 5-year annualized return of 10.79%
- VUSA: 5-year annualized return of 14.69%
Remember, past performance doesn’t guarantee future results. The last 5 years have been particularly good when compared to longer histories. This is why it’s important to analyse across different time periods.
Which one is right for you? It depends on your investment goals, risk tolerance, and overall portfolio strategy. VWCE offers more diversification but at a higher cost, while VUSA provides focused exposure to the U.S. market at a lower cost.
Remember, these figures are as of October 2024 and can change. Always check the most recent fund documentation and consider consulting with a financial advisor before making investment decisions. Your specific tax situation and local regulations may also impact which ETF is most suitable for you.
The information provided in this article is for educational purposes only and should not be considered as financial advice. Investing in ETFs carries risks, and past performance does not guarantee future results. Always conduct your own research and consult with a qualified financial advisor before making any investment decisions. It’s important to note that everyone’s financial situation is unique, and the information presented here may not be suitable for your individual circumstances