Exchange-traded funds (ETFs) are popular investment vehicles that offer exposure to a variety of asset classes, sectors, regions, and themes. ETFs are collections of securities that trade on an exchange like stocks, and they typically track an index or a basket of assets. ETFs can provide diversification, liquidity, transparency, and low-cost access to the markets.

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However, not all ETFs are created equal. There are often multiple ETFs that invest in the same thing, and it can be challenging to know which one is the best to choose. How do you select the best ETF for your portfolio? What are the criteria that you should consider when comparing different ETFs?

In this article, we will answer these questions and provide you with a guide on how to choose the best ETF for your portfolio. We will discuss some of the key factors that you should look at when evaluating ETFs, such as:

• Total expense ratio
• Use of profit
• Replication method
• Fund size
• Currency hedge

We will also provide some tips on how to research and analyze ETFs, and how to diversify your portfolio with ETFs.

Total Expense Ratio

One of the most important factors to consider when choosing an ETF is the total expense ratio (TER). The TER is the annual fee that the ETF charges to cover its operating costs, such as management, administration, custody, and auditing. The TER is expressed as a percentage of the fund’s net asset value (NAV), and it reduces the return that the investor receives from the ETF.

The TER can vary widely among different ETFs, even if they invest in the same thing. For example, according to Morningstar, the TER of the iShares Core S&P 500 ETF (IVV) was 0.03%, while the TER of the SPDR S&P 500 ETF Trust (SPY) was 0.09%. Both ETFs track the same index, the S&P 500, but the iShares ETF charges a lower fee than the SPDR ETF.

Therefore, when choosing an ETF, you should look for the one that has the lowest TER possible, considering the other criteria. A lower TER means that you keep more of your returns, and that the ETF can track its underlying index more closely. A higher TER means that you pay more for the same exposure, and that the ETF can deviate more from its underlying index.

However, the TER is not the only cost that you should consider when investing in ETFs. You should also take into account the trading costs, such as bid-ask spreads, commissions, and taxes. The trading costs depend on the liquidity, popularity, and structure of the ETF, as well as the market conditions and the broker that you use. You should compare the total cost of ownership (TCO) of different ETFs, which includes both the TER and the trading costs, to find the best value for your money.

Use of Profit

Another factor to consider when choosing an ETF is the use of profit. The use of profit refers to how the ETF distributes or reinvests the income that it receives from its underlying assets, such as dividends, interest, or capital gains. There are two main types of ETFs based on their use of profit: accumulating ETFs and distributing ETFs.

Accumulating ETFs reinvest the income that they receive from their underlying assets back into the fund, increasing the NAV of the ETF. Accumulating ETFs do not pay any dividends or distributions to the investors, and they allow the investors to benefit from the compounding effect of reinvesting the income. Accumulating ETFs are suitable for investors who seek long-term growth and do not need current income from their investments.

Distributing ETFs pay out the income that they receive from their underlying assets to the investors, either quarterly, semiannually, or annually. Distributing ETFs reduce the NAV of the ETF by the amount of the distribution, and they provide the investors with a regular income stream from their investments. Distributing ETFs are suitable for investors who seek current income and do not mind paying taxes on the distributions.

Therefore, when choosing an ETF, you should look for the one that matches your investment strategy and objectives. If you want to maximize your long-term growth and defer taxes, you should choose an accumulating ETF. If you want to generate a steady income and pay taxes as you go, you should choose a distributing ETF.

Replication Method

A third factor to consider when choosing an ETF is the replication method. The replication method refers to how the ETF mimics the performance of its underlying index or basket of assets. There are three main types of replication methods: full replication, sampling, and synthetic replication.

Full replication is the simplest and most transparent replication method. Full replication means that the ETF holds all the securities that make up its underlying index or basket of assets, in the same proportion as the index or basket. Full replication allows the ETF to track its underlying index or basket of assets very closely, with minimal tracking error and tracking difference. Full replication is suitable for ETFs that track broad, liquid, and diversified indices or baskets of assets, such as the S&P 500 or the MSCI World.

Sampling is a more flexible and cost-efficient replication method. Sampling means that the ETF holds a subset of the securities that make up its underlying index or basket of assets, rather than holding all of them. Sampling allows the ETF to reduce its operating costs, such as transaction fees, rebalancing costs, and dividend withholding taxes, by holding fewer securities. Sampling is suitable for ETFs that track narrow, illiquid, or complex indices or baskets of assets, such as the MSCI Emerging Markets or the Bloomberg Barclays Global Aggregate Bond.

Synthetic replication is the most complex and controversial replication method. Synthetic replication means that the ETF does not hold any of the securities that make up its underlying index or basket of assets, but instead uses derivatives, such as swaps or futures, to replicate the performance of the index or basket. Synthetic replication allows the ETF to overcome some of the challenges and limitations of physical replication, such as access, liquidity, and cost issues. Synthetic replication is suitable for ETFs that track hard-to-reach, exotic, or leveraged indices or baskets of assets, such as the FTSE China A50 or the S&P 500 2x Leveraged.

However, synthetic replication also involves some risks and drawbacks, such as counterparty risk, collateral risk, regulatory risk, and transparency risk. Counterparty risk is the risk that the derivative provider fails to deliver the agreed-upon performance of the index or basket of assets. Collateral risk is the risk that the collateral that the ETF holds to back up the derivative contract loses value or becomes illiquid. Regulatory risk is the risk that the rules and regulations that govern the use of derivatives change or become more restrictive. Transparency risk is the risk that the ETF does not disclose enough information about its derivative contracts, collateral, and counterparties.

Therefore, when choosing an ETF, you should look for the one that uses the most appropriate replication method for its underlying index or basket of assets. If possible, you should prefer full replication over sampling, and sampling over synthetic replication, as they offer more transparency, simplicity, and reliability. However, you should also consider the trade-offs between tracking accuracy, cost efficiency, and risk exposure, and choose the replication method that best suits your risk tolerance and return expectations.

Fund Size

A fourth factor to consider when choosing an ETF is the fund size. The fund size refers to the total market value of the ETF, which is calculated by multiplying the number of shares outstanding by the NAV per share. The fund size can indicate the popularity, liquidity, and stability of the ETF.

The fund size can affect the ETF in several ways, such as:

• A larger fund size can imply a higher demand and a lower trading cost for the ETF, as it can attract more investors and market makers, and increase the trading volume and liquidity of the ETF.
• A larger fund size can imply a lower operational risk and a higher survival rate for the ETF, as it can generate more revenue and economies of scale for the fund provider, and reduce the likelihood of closure or merger of the ETF.
• A larger fund size can imply a higher tracking error and a lower tax efficiency for the ETF, as it can make it more difficult and costly for the fund manager to rebalance the portfolio and manage the cash flows of the ETF.

Therefore, when choosing an ETF, you should look for the one that has a sufficient fund size to ensure its viability and attractiveness. However, you should also be aware of the potential drawbacks of a too large fund size, and balance them with the other criteria. As a rule of thumb, you should avoid ETFs that have a fund size below $100 million, as they may face liquidity, profitability, and sustainability issues.

Currency Hedge

A fifth factor to consider when choosing an ETF is the currency hedge. Currency hedge is a technique that an ETF uses to reduce or eliminate the impact of currency fluctuations on the fund’s returns. Currency hedge involves using derivatives, such as futures or swaps, to lock in the exchange rate between the fund’s base currency and the currency of the underlying assets. Currency hedge can protect the fund from losing value when the base currency appreciates against the foreign currency, or vice versa.

To decide whether to use currency hedge or not, investors should look at their own:

• Investment objective, which is the goal and time horizon of their investment
• Risk tolerance, which is the level of risk that they are willing and able to accept
• Currency outlook, which is their expectation and preference for the future direction and movement of the currencies

Generally, investors who have a short-term investment objective, a low risk tolerance, and a negative currency outlook may prefer to use currency hedge, as it can reduce the volatility and uncertainty of their returns. On the other hand, investors who have a long-term investment objective, a high risk tolerance, and a positive currency outlook may prefer not to use currency hedge, as it can increase the cost and complexity of their investment.

Conclusion

Choosing the best ETF for your portfolio can be a challenging task, as there are many factors and criteria that you need to consider. However, by following the guidelines and tips that we have discussed in this article, you can make an informed and confident decision that suits your investment objective, risk tolerance, and currency outlook.

To recap, here are the main criteria that you should look at when comparing and selecting ETFs:

• Total expense ratio
• Use of profit
• Replication method
• Fund size
• Currency hedge

We hope that this article has helped you understand how to choose the best ETF for your portfolio. If you have any questions or feedback, please feel free to leave a comment below. Thank you for reading and happy investing! 🙌

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