In order to gain exposure to a market (or a corresponding index), it makes sense for private investors to invest in an Exchange Traded Fund (ETF) that tracks that market or index. As there are often several funds that track the same index, you will have to choose between different index funds. Because ETFs come in many forms, there are several attributes to consider when comparing two index funds before you invest.
You should consider the following three primary attributes when choosing your ETF because these characteristics will have the greatest influence on your net returns and risk level: issuer reliability, pricing and volume are key selection criteria when you have identified a market to cover. Then there are other important (but more secondary and which we will see next) attributes to consider:
- Strength of ETF issuers: To simplify your selection, look for a well-established issuer, such as Vanguard and iShares, that will have low operational risk, and thus low risk of fraud or loss. These issuers also typically offer other benefits, such as low fees and high assets under management (see below).
- ETF management, administration and rebalancing fees (Total Expense Ratio (TER) or expense ratio (ER)). The TER is the total amount of fees taken out of the fund’s assets each year (expressed as an annual percentage) to pay for the administration of the fund, including the operating costs, salaries, marketing and overhead of the company managing the fund. In order to receive the highest net amount, you will reduce the fees that the fund takes from your assets and aim to keep these fees to a minimum (approximately 0.1%). This is the most important measure you should consider! If there is no difference in the other attributes and they track the same index (beware, some indices have different components – like the FTSE or MSCI Emerging Markets with different exposure to China), you should choose the lowest TER possible. The difference in returns will increase proportionally to the savings in fees charged, which means that you will mechanically increase your return by reducing the fees of a passive fund.
- Assets under management (AuM) is the amount of money managed by the fund, i.e. the size of the fund. Larger funds can generally better replicate the index with better sampling and apply economies of scale to reduce fees. The popularity of larger funds is also a sign of respectability and longevity, which means they are less likely to close for any reason. Large size also improves the liquidity of the ETF, which means you are more likely to find a buyer in case you want to trade it without impacting the market. Thus, you will get a better price and a lower spread in case you want to sell, but also buy it. So, in the ETF business, a small size is not an attractive feature. Always look for the total assets of the entire fund (umbrella). There may be different share classes, with currency hedging or a client segment, but what matters is the total of the ETF when you assess its size.
Secondary attributes are also important factors that will guide your decision, but these aspects are not a priority, especially for beginners:
- Currency hedging: To protect you from currency differences between your investment and your home currency, some funds offer hedging of movements through derivatives: As long as it is financially feasible, you should not intend to hedge foreign currency exposure for equity funds, but hedging for bond funds is generally desirable.
- Dividend distribution: One class of funds distributes dividends to you (distributing ETFs) while the other accumulates and reinvests them directly (accumulating ETFs). Your choice will depend on whether you need the dividends for expenses or whether your jurisdiction’s tax rules make one choice better than the other for tax and reporting purposes. There is generally no advantage to accumulation funds and in Switzerland you will be taxed on the virtual dividends anyway, as if they were distributed. Therefore, in terms of tax reporting, it is generally easier to have your dividends distributed. In the long run, you won’t need to reinvest the dividends in an accumulation fund, which is advantageous if you plan to reinvest your dividends. Conversely, distribution funds provide cash to rebalance your portfolio or for expenses, which is useful when you retire.
- ETF Trading Exchange: Depending on where they are traded, additional transaction fees may apply. Smaller marketplaces or exchanges also have lower trading volume, resulting in higher spreads that hurt ETF holders because they produce higher buy prices and lower sell prices for ETF investors.
- A sufficient number of stocks: If the number of stocks in the fund is too small compared to the number of components of the index, you risk not tracking the index accurately (the so-called tracking error). This problem is related to the problem of small ETFs. If the universe is too large, a small ETF would incur too many costs to include all components and would have to reduce its sampling or include only the stocks with the largest market capitalization. As a general rule, therefore, one should look for ETFs whose number of different stocks is as close as possible to that of the index.
- ETF trading volume: A useful secondary criterion is the trading volume of the fund. It is closely related to AuMs, as a larger fund trades a higher volume than smaller funds. High volume indicates that you can easily buy and sell shares of the fund with a small bid/ask spread. This means that you will have less price uncertainty when trading and will not have a huge impact on the market if you are trading a large block of shares (which may apply in the case of small ETFs covering a single country or a bond segment for example). Even if you do not intend to sell any position in the short term, the question of market impact will apply when you choose to buy the shares.
- ETF domicile: You must evaluate the domicile of the fund based on its availability and taxation for a given ETF. In most cases, Irish ETFs work best for all non-US investments. If you are domiciled in the U.S., you will have access to U.S.-based ETFs, but for non-U.S. residents, this is not always available. For funds investing in US equities (US tech, S&P 500, global or developed world with US equities), US domicile is an obvious advantage: If you invest in a fund that invests in US equities, 30% of the dividends will be withheld. You can then reclaim the entire U.S. dividend and cancel the withholding tax of a fund domiciled in the U.S. if your country of domicile has a favorable double taxation agreement and if your tax authorities give you the option, as is the case in Switzerland. As a second choice for U.S. equities, you can consider an Irish fund, which effectively has a withholding tax of only 15% for Swiss investors. You will find more details in the specific article on withholding tax.
- Replication: There are two main methods of replication: physical replication and synthetic replication. Physical replication means that the fund will directly hold the shares of the companies in the index. This is the preferred approach in the United States. Synthetic replication means that the ETF manager will use derivatives to replicate market performance. Unless you need synthetic replication for a tax-advantaged retirement plan (such as Lyxor’s or Amundi’s developed market funds), we suggest you consider only physical replication (e.g., with Vanguard and iShares issuers). For more information on the topics of domicile and replication, you can use the search function on this site.
- Tracking error is the difference in performance between your fund and the index. In a passive investment, you want it to be as small as possible: This difference includes the TER as well as the differences in performance between the fund and the index. The tracking error and the performance itself can help you choose a low-cost index fund that will track the market closely. Historical returns, on the other hand, are not a basis for asset allocation, as opposed to price level and performance expectations (see the article “Capital Market Assumptions“), because past returns are not a signal for the future and returns oscillate around a long-term average (i.e. exuberant returns often give way to weaker performances).
Overall, you can focus on the three primary parameters if you are making your very first investments. As you increase the number of constituents in your portfolio, you can then progressively examine the secondary aspects to ensure that there are no anomalies in your assessment. This portfolio hygiene should not lead to too much back and forth or a proliferation of different product lines, but to a healthy and regular review of your investment situation and strategy.