With more than 8,000 exchange trade funds (ETFs) to choose from, even an experienced investor could be forgiven for feeling overwhelmed. Fortunately, a few simple steps can narrow the choice among these listed investments, that involves a collection of assets and often track an underlying index, down to something more manageable.
The first move
The first step in selecting an ETF is to define the market segment – that is the type of asset that you want to buy. It is possible to choose ETFs that concentrate on asset classes such as equity, fixed income and commodity ETFs and those choices will usually deliver different outcomes.
Investors can then refine their focus within each asset class. For example, equities are often differentiated by geography (region, country or stock exchange), by market capitalisation (large, mid-sized or small companies) or by their economic sector, such as technology or energy.
Investors might also pursue specific investment themes such as electric vehicles, artificial intelligence or the rise of millennial consumers.
Sustainable ETFs
Within the same market segment, companies might be differentiated by their perceived ethical credentials – for example, “sustainable” ETFs may focus on specific themes such as companies with low levels of water usage or carbon emissions.
Alternatively, sustainable funds might simply exclude securities with unwanted characteristics, such as major polluters, from broader stock market benchmarks.
Investors focused on such measures should look closely at funds’ investment policies and portfolios, however, as the same company can be viewed as having a very high environmental, social and governance score by one index provider and a very low one by another. Electric car maker Tesla and General Motors, its more traditional rival, are startling examples of this lack of consensus.
Fixed income ETFs
Fixed income ETFs are commonly filtered by the type of issuer (corporate or government), by credit rating (investment grade or high yield) or by maturity date. Investors can narrow the focus of the exposure still further by considering specific types of underlying securities, for example convertible bonds (where the return will be driven, in part, by movements in the company’s share price) or floating-rate bonds, which offer investors protection against rising inflation.
Investment strategy
Investors also have an ever-widening array of potential investment approaches at their fingertips.
ETFs were traditionally purely passive vehicles, seeking to replicate the return of an underlying market index. But there is now a small, but fast growing, army of actively managed funds that seek to outperform their benchmark. In the first five months of the year, more active ETFs than passive ones were launched in the US, according to data providers FactSet and Ultumus.
A separate concept, “smart beta”, straddles the active and passive investment approaches. Here a fund seeks to build a portfolio skewed to one or more “factors” that have historically been correlated with outperformance, such as value, dividend generation, momentum, small size or low volatility.
The individual holdings are, however, selected and weighted according to a pre-written formula, rather than being actively chosen by the fund manager. As ever with investment, there is a lively debate about the efficacy of smart beta approaches.
Practical considerations
Depending on where it is listed, a product might simply be unavailable to an investor, or the cost of trading the ETF might be inordinately high.
In addition, fund managers may often provide multiple share classes of otherwise identical ETFs with different dividend or coupon policies. This is an important factor to consider as it can affect investors’ long-term returns significantly.
Accumulating share classes reinvest dividend and coupon payments, buying more stocks and bonds, while distributing share classes pass these payouts to investors as a regular income stream. This income stream is often taxed at a different rate to that of a capital gain.
Currency risk
Investors should also consider the share class currency. Holding a share class denominated in a foreign currency will naturally subject investors to potentially adverse FX moves.
In other words, the price of the ETF in the investor’s home currency will fluctuate with currency moves, potentially leading to losses unrelated to the return of the underlying assets. Although an FX gain is equally likely, this currency mismatch may inject some unwanted volatility.
ETF issuers often provide hedged share classes that enable investors to hedge against this risk. In this scenario, the investment performance will be aligned with that of the underlying assets, but the cost of the hedging will progressively reduce returns in the long term. – Copyright The Financial Times Limited 2020
