Criteria for choosing ETFs and ETCs

You have begun to familiarise yourself with this financial instrument, which lends itself very well to long-term investing. Now it’s time to get practical and see how to select ETFs and ETCs.

The selection of ETFs is very important and requires care and attention. It is a step-by-step process that begins with an analysis of each product’s characteristics and ends with identifying the most efficient ones to meet your financial objective.

Choosing ETFs involves two processes:

• Objective, the analysis of the characteristics and data of each ETF.
• Subjective, the investor’s financial planning, which includes the financial objective, time perspective and degree of risk.

Let’s see what steps you need to take when choosing an ETF.

1. Select and classify ETFs by class: monetary, equity, bond. As mentioned, structured ETFs are not suitable for investment, so you should leave them alone.
2. Analyse the stocks or bonds that make up the basket of each ETF. Basically, you have to verify that the ETF is in line with your investment idea. Now, a clarification. You do not have to analyse all ETFs on the market one by one, only those related to the benchmark you want to invest in. For example, if you are not interested in investing in the emerging bond market, you will ignore all ETFs that are composed of bonds issued in that specific geographic area.
   
   There are so many issuers and, consequently, so many ETFs on the same benchmark. You have to choose the one that best represents what you want to invest in. For example, if you want to buy an ETF with shares from Asian countries but you don’t want Chinese securities, maybe because the Evergrande case scares you, you have to look, among all the ETFs, for one whose basket is composed of shares from Asian countries but without Chinese securities.
   
   In addition, you need to check that the ETF basket is actually diversified and there is no skewing towards a particular area. Let me give you another example. Some ETFs replicate the world stock market, so with stocks from a bit of all five continents. However, there are ETFs with baskets composed of 35-40% American stocks and others in which the percentage is double. Understand that if your goal is to maximally diversify your equity investment, an ETF composed of 80% US stocks is not for you.
   
   My advice is not to base your choice on performance, as ETFs on the same benchmark but with differently composed baskets can give very different results. Always base your decisions on your own investment idea.
3. Your degree of risk. If you are a very prudent investor, your choice should fall on physically replicated ETFs, so that you avoid including in your portfolio synthetically replicated ETFs, which are a bit riskier, unless there are no alternatives (i.e., there is no physically replicated ETF on a specific benchmark, such as for African equities). I also personally prefer physically replicated ETFs, but everyone is different.
4. Check how much the exchange rate affects you, if at all. You need to distinguish between:
   • Currency of the asset, i.e., the currency of the stocks or bonds that make up the ETF basket;
   • Currency of denomination, the currency in which the ETF was issued;
   • Trading currency, the currency in which the ETF is traded (e.g., in euro if listed on the Frankfurt Stock Exchange or in dollars if listed on the New York Stock Exchange).

   This is an aspect you should not underestimate. For example, for me, as an Italian, even if an ETF on the S&P 500 index is quoted on the Milan or Frankfurt stock exchange, and therefore in euro, the stocks inside are in US dollars. So, the Eur-Usd exchange rate will affect the performance of the ETF anyway (either positively or negatively).

   To overcome this variable, a saver who wishes to invest in ETFs listed in a foreign currency but without the exchange rate risk can opt for a hedged ETF. A hedged ETF contains an internal mechanism, realised through derivative contracts, which greatly reduces the exchange rate risk (although not entirely). However, this hedging has a cost that will affect the price of the ETF.

5. Dividends. Not all, but many ETFs pay dividends (like a common stock), based on the dividends paid by the securities within them. These can be:
   • distributed. On the ex-dividend day, the amount of the dividend is deducted from the ETF price and, on the payment day, credited to the investor’s account (multiplied by the number of units the investor holds in their portfolio).
   • accumulated. Dividends are not distributed but accumulated within the fund, increasing the price of the ETF.

   The choice is up to you. If you need an income to meet some expenses or to spend as you see fit, then you should choose ETFs that distribute dividends. If, on the other hand, you don’t need an extra income in your account, it’s much better to go for ETFs that accumulate dividends because, as explained through compound interest, they perform better in the long run than distributing ones.

6. Another important factor in your decision-making is liquidity, i.e., whether it is a heavily traded ETF. An ETF is defined as liquid when trading volumes are high and supply and demand are not problematic or anomalous. Conversely, if an ETF is illiquid, it means that not many trades occur and supply and demand are far apart. This leads to difficulties when you want to sell an ETF, and you are often forced to do so at a very disadvantageous price.

   The liquidity of an ETF can depend on several factors:

   • liquidity of the benchmark. The formula is simple: the more liquid and traded the benchmark is, the more liquid the ETF will also be.
   • capitalisation of the ETF. Again, the relationship is very clear: the greater the assets under management (i.e., the total savings of all investors), the greater the liquidity of the ETF.
   • life of the ETF. Simply put, how many years an ETF has been listed. ETFs that have been listed for longer tend to be more liquid and more heavily traded, probably because, having been on the markets longer, they tend to be more trusted by investors. Moreover, the longer the time series (i.e., the past years’ performance) available to analyse, the more accurate the performance analysis will be.
   • listing market. That is the market where the ETF is listed and traded. Some ETFs are listed on multiple exchanges. Your choice should fall on the one that is most heavily traded. This, however, also depends on the bank or broker you use for your investments.

   In conclusion, you should only invest in liquid ETFs, so that, if you need to divest, you will have no problem doing so. How do you decide whether an ETF is heavily or thinly traded? Generally, look at the daily traded value (the price of the ETF multiplied by the number of units traded in a day), which in my opinion should be at least 600-700 thousand dollars.

7. Costs. A cost that few investors take into consideration is the percentage difference between the bid (the price buyers are willing to pay) and the ask (the price sellers are asking), which can vary between ETFs that invest in the same benchmark. This, as you have seen, depends very much on the liquidity of the ETF but it isn’t the only factor. Also, volatility at a given moment can contribute to widening the bid/ask range. The wider the bid/ask percentage difference, the more this will negatively affect your return from the ETF.

   One figure you should pay attention to is the TER (Total Expense Ratio), an indicator that allows you to calculate the annual cost of the ETF. The TER includes all of the ETF’s administrative, marketing and legal expenses. Like all costs, the TER affects the performance of the ETF, so you should choose an ETF with a low TER.

   The bid/ask percentage difference and the TER, together with your broker’s commissions, give you a good idea of the total cost of an ETF.

Choosing an ETC is pretty much the same as choosing an ETF; it differs only in a couple of ways:

• Issuer;
• Replication type.

1. The issuers of ETCs are at risk of default, so it is important to check their reliability. Without getting bogged down in the analysis of financial statements, just check a couple of things: the rating, if any, from a specialised agency and, if the issuer or its parent group is listed, the trend of its share price. If the issuer has received a bad rating or its shares are collapsing, it is a good idea to investigate why.
2. The type of replication in ETCs is even more important than in ETFs. I do not recommend synthetic replication; physical replication is much safer and more suitable for long-term investments. I prefer physical replication in ETFs, and even more so in ETCs.

If anything is unclear, don’t worry. I will now show you some examples of how I choose an ETF, to clarify the process better.