ETF: How to find the best ETF
What is an ETF?
Exchange-traded funds, commonly known as ETFs, are a collection of various securities such as bonds, shares, money market instruments, etc., that often track an underlying asset. Simply put, ETFs are a mashup of different investment avenues. They offer the best attributes of two popular financial assets mutual funds and stocks.
ETF funds are somewhat similar to mutual funds in terms of their structure, regulation, and management. Additionally, just like mutual funds, they are a pooled investment vehicle that offers diversified investment into various asset classes like stocks, commodities, bonds, currencies, options, or a blend of these. Moreover, they can even be traded like stocks on the stock exchanges.
In the simple terms, ETFs are funds that track indexes such as S&P 500 etc. When you buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate the performance of the Index. They don't try to beat the market, they try to be the market.
ETFs typically have higher daily liquidity and lower fees than Mutual Fund schemes, making them an attractive alternative for individual investors.
How To Find The Best ETFs
As we saw in the previous story, an ETF, or exchange-traded fund, is a rather simple product which just tracks an index. So, by investing in an ETF, you are effectively investing in its underlying index. Your returns will also likely be index-like.
As the popularity of exchange traded funds continues to rise, the number of ETFs you can choose from is also expanding rapidly. So how can you find the best ETFs to invest in? And what is the best ETF investing strategy to help you achieve your financial goals?
Start by regularly checking the latest ETF news and ETF Leaders, a weekly column highlighting the best ETFs to buy and watch.
here. some Factors Analysis to Find the best of ETFs.
Underlying index
An ETF tracks an index, so first decide which index you would like to invest in. Dow jones and Nasdaq comprise large-cap stocks. So, by investing in ETFs that track them, you are investing in large caps. There are ETFs tracking mid and small caps as well. Then there are those that track international indices.
Liquidity
While investing in an ETF, it is important to ensure that you can buy and sell its units with ease. Thus, it is important to choose an ETF that trades with a fairly high trading volume. This is similar to investing in a liquid or an illiquid stock. A liquid stock provides you with a smooth buying and selling experience. But with an illiquid stock, your order may remain unexecuted for a long time.
Entities called authorised participants (APs) play an important role in maintaining the liquidity of ETFs. An AP is a large financial institution, such as an investment bank, that purchases or sells shares required to create a unit of ETF based on the market demand. When the demand of ETFs is high, the AP purchases more stocks and helps create more units of the ETF. Similarly, when the demand of the ETF is low, the AP removes ETF units from the market.
Expenses
While choosing a fund, expenses are an important consideration. In the case of actively managed funds, an investor may give preference to performance over expenses but in the case of ETFs, where the returns are almost certain to be like the underlying index, it would make sense to go for the cheapest ETF. For two ETFs that track the same index, go for the cheaper one, provided that the rest of the determinants are the same.
Different Types of ETFs
Common types of ETFs available today
The majority of ETFs are index-based and aim to replicate a specific index or benchmark. These indexes could be based on stocks like the Hang Seng or a bond index. Whatever the underlying asset, an index ETF aims to track index performance by holding all or a representative sample of the index.
For example, Hong Kong’s Hang Seng Index tracks the top 50 companies by size listed on the Hong Kong Stock Exchange. An ETF that tracks the Hang Seng will typically hold all 50 stocks in the same proportion as the Index.
Equity ETFs
Equity ETFs track an index of equities. You can choose ETFs covering large businesses, small businesses, or stocks from a specific country. Equity ETFs also let you target sectors that might be doing well at that time, like tech stocks or banking stocks, which makes them a popular choice.
Bond/Fixed Income ETFs
It’s important to diversify your portfolio. Spreading your investment risk is just good practice. That’s why most professionals will also invest in fixed-income and bond ETFs that provide steady return at potentially lower risk than equity ETFs.
Commodity ETFs
Often harder to access than stocks, ETFs are a great way to get into commodities like gold, silver or oil. These are an attractive alternative to stocks to further diversify your portfolio and risk. However, commodity ETFs can be less transparent than index or stock ETFs. They often don’t directly own the underlying asset, like gold, but use derivatives instead. Derivatives track the underlying price of the commodity but can carry more risk, such as counterparty risk, than an ETF which owns the underlying asset directly.
Currency ETFs
Currency ETFs will invest in either a single currency, like the US dollar, or a basket of currencies. The ETF will either invest in the currency directly, use derivatives or a mix of the two. Using derivatives can potentially add more risk to the ETF, so you need to be sure what you’re buying. You’d buy a currency ETF if you thought the underlying currency is likely to strengthen or if you wanted to protect or hedge your investment portfolio. Some ETFs that invest in overseas markets may already ‘hedge’ against currency risk.
Specialty ETFs
Two fund types that have emerged in recent times to meet very specific needs are leveraged funds and inverse funds. These specialty ETFs offer much greater growth potential but also a much higher risk.
Inverse funds go up when the target index goes down similar to investors short-selling a stock as its price falls
Leveraged funds aim to maximize returns by borrowing more money (leverage) to invest. You’ll recognize these ETFs as they typically say by how much they are leveraged, for example, 2X will borrow an extra $1 for every $1 investors put into the fund.
As well as offering potentially high returns, both of these ETF types can be high risk, so do your homework and know what you’re buying.
Factor ETFs
Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. Institutional investors and active managers have been using factors to manage portfolios for decades. A common way to access factors is through rules-based ETFs. often referred to as “Smart Beta”.
Sustainable ETFs
The range of sustainable ETFs available is growing rapidly. Sustainable investing combines traditional investment approaches with environmental, social and governance insights. Sustainable investing is growing across a wide range of investors. The demand is being driven by trends in demographic shifts, government policies and evolving views on risk.
Advantages of ETFs
ETFs have several advantages over traditional open-end funds. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs, and tax benefits.
Trading flexibility
Traditional open-end mutual fund shares are traded only once per day after the markets close. All trading is done with the mutual fund company that issues the shares. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid for new shares when buying that day and the price they will receive for shares they sold that day. Once-per-day trading is fine for most long-term investors, but some people require greater flexibility.
ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares is continuous during normal exchange hours. Share prices vary throughout the day, based mainly on the changing intraday value of the underlying assets in the fund. ETF investors know within moments how much they paid to buy shares and how much they received after selling.
Tax benefits
ETFs have 2 major tax advantages compared to mutual funds. Due to structural differences, mutual funds typically incur more capital gains taxes than ETFs. Moreover, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas mutual funds pass on capital gains taxes to investors through the life of the investment. In short, ETFs have lower capital gains and they are payable only upon sales of the ETF.
The tax situation regarding dividends is less advantageous for ETFs. There are 2 kinds of dividends issued by ETFs, qualified and unqualified. In order for a dividend to be classified as qualified, the ETF needs to be held by an investor for at least 60 days prior to the dividend payout date. The tax rate for qualified dividends varies from 5%–15% depending on the investor's income tax rate. Unqualified dividends are taxed at the investor’s income tax rate.
Lower costs
Operating expenses are incurred by all managed funds regardless of the structure. Those costs include, but are not limited to, portfolio management fees, custody costs, administrative expenses, marketing expenses, and distribution. Costs historically have been very important in forecasting returns. In general, the lower the cost of investing in a fund, the higher the expected return for that fund.
ETF operation costs can be streamlined compared to open-end mutual funds. Lower costs are a result of client service related expenses being passed on to the brokerage firms that hold the exchange-traded securities in customer accounts. Fund administrative costs can go down for ETFs when a firm does not have to staff a call center to answer questions from thousands of individual investors.
ETFs also have lower expenses in the area of monthly statements, notifications, and transfers. Traditional open-end fund companies are required to send statements and reports to shareholders on a regular basis. Not so with ETFs. Fund sponsors are responsible for providing that information only to authorized participants who are the direct owners of creation units. Individual investors buy and sell individual shares of like stocks through brokerage firms, and the brokerage firm becomes responsible for servicing those investors, not the ETF companies.
Portfolio diversification and risk management
Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment.
ETFs are now traded on virtually every major asset class, commodity, and currency in the world. Moreover, innovative new ETF structures embody a particular investment or trading strategy. For example, through ETFs an investor can buy or sell stock market volatility or invest on a continuous basis in the highest yielding currencies in the world.
In certain situations, an investor may have significant risk in a particular sector but cannot diversify that risk because of restrictions or taxes. In that case, the person can short an industry-sector ETF or buy an ETF that shorts an industry for them.