Investing Basics: Passive Investment, Active Selection

There are over 1,300 Exchange Traded Funds (ETFs) listed on European stock exchanges, and countless more listed overseas with a wide variety in terms of how funds are invested and structured. Matt Hougan considers how to find the right fund to suit your needs?

Selecting the right ETF can be daunting for those new to passive investing. With little consistency in terms of naming convention and differences between physically replicated and synthetic funds, as well as short and leveraged products, some may find themselves dissuaded from investing in what is an increasingly popular asset class.

However, the adoption of a few key steps in the selection process can make things considerably easier:

First, Find the Right Index

One of the most common mistakes people make when choosing an ETF is simply looking at what it says on the tin and figuring that’s good enough.

If a fund says it’s a ‘China’ ETF, it must give good exposure to China, right?

Not exactly. Two funds that both claim to provide exposure to China … or Autos … or Gilts … may sound similar, but if you dig underneath the surface, you’ll find wildly different portfolios (and therefore get wildly different returns).

Consider two of the most popular China ETFs listed in the US: the iShares FTSE China 25 ETF (FXI) and the PowerShares Golden Dragon China Portfolio (PGJ). Both funds are well-established, with 10+ year track records.

FXI has more than $5 billion invested in it, while PGJ has $250 million; in the past month alone (through 10th October 2014), FXI has outperformed PGJ by more than 5%.

What gives? The two funds have different takes on ‘China,’ that’s what.

FXI owns mostly large, government-owned financial and energy companies, with established business lines and defensible profits. It is 52% invested in banks and has a weighted average market cap of $114 billion. In other words, it’s a defensive portfolio.

PGJ, in contrast, only holds stocks in companies listed on the New York Stock Exchange that do the majority of their business in China. It is 43% invested in Technology, with just a 5% weight to banks. Its average market cap is $34 billion. It’s designed for the more aggressive China investor.

Is it any wonder these two ‘China’ ETFs performed so differently?

The choice of index and the portfolio it providers trumps all other choices, so look here first.

Cost

Even if there are several ETFs tracking the same index, there can be large divergences between vehicles when it comes to costs.  For example, UK equities are a likely asset class choice for any investor putting together an investment portfolio.

According to data from Morningstar there are twenty four ETFs that track large cap UK equities, fifteen of which track the main UK equity index, the FTSE 100.

When taking a first look, the costs vary considerably. The annual net expense ratios range from 0.10% for the Vanguard FTSE 100 ETF to 0.48% for the iShares MSCI UK Large Cap ETF.

Don’t stop there, however. Industry experts will tell you that a total expense ratio – or TER – does not cover the full cost.  ‘Far more important is the tracking of the fund versus the index,’ said Michael John Lytle, chief development officer at Source. ‘Paying a low fee can become relatively irrelevant if the fund is underperforming.’

The key measure is what’s known as ‘tracking difference,’ which compares the return of the fund and the return of its index over a one-year time period.

Looking at the same pool of twenty four large cap UK equity ETFs shows the power of this statistic.

Recorded on a cumulative annual basis in Euros, the UBS FTSE 100 ETF and iShares FTSE 100 trailed their indexes by only 0.01%, yet this jumps to 0.29% for the Source FTSE 100 ETF and 0.31% on the ComStage FTSE 100 TR ETF.

Consider Trading Costs

Finally, remember to consider trading costs. Unlike mutual funds, you must pay both a commission and a spread when buying an ETF, just like when you buy a stock.

The wider the spread – the difference between the bid and the ask – the more it costs you to buy.

These costs can be prohibitive, and can easily overwhelm small differences in expenses.

So choose carefully.

 
Used properly, ETFs can be enormously valuable tools, offering you institutional-quality exposures at extraordinarily low prices. But with 1,300+ choices, it pays to take five minutes and dig a little deeper to find the best fund to meet your needs.