Monday, September 17, 2018

Considerations of ETF Selection

ETFs are great tools to start off passive index investing, whether you want to follow the Bedokian Portfolio or other investment strategies and approaches. Before you jump right in, here are some considerations that you should take note of.

Consideration #1 – The Index

The index determines the make-up of the underlying securities of the ETF. Take the Straits Times Index (STI) for instance, both the STI ETF and the Nikko AM STI ETF track it, but there could be some slight differences between them, such as their proportions of the STI components and how closely the ETF tracks the index.

Additionally, you may also want to see the sector/industry exposure of the index, as well as regional/country exposure if applicable. This is important due to diversification.

Consideration #2 – The Structure of the ETF

I had mentioned earlier about physical and synthetic ETFs. Although in my ebook I had stated that physical ETFs are preferred, due to the counterparty risk that synthetic ETFs have, the latter do track the index closer than the former. The verdict of going with physical or synthetic is up to you.

The other thing to take note of would be whether you want to have dividends from the ETF. An ETF could be capitalising (reinvest the dividends from the underlying securities back to the ETF) or distributing (distribute the dividends) on a periodic basis, so again it is your call which one is more suitable.

Consideration #3 – Total Expenses Ratio

Expenses are part and parcel of running an ETF, and ETF providers impose these expenses as a percentage (dubbed as total expenses ratio or TER) of the entire investment fund, so it is important to select an ETF with as low TER as possible.

As TER is imposed yearly, there is compounding effect at work. For example, take two similar ETFs called A and B, with an annual TER of 0.5% and 1% respectively. Assuming an initial $10,000 investment with a 10% annual return, after 20 years ETF A will return $61,416 while ETF B returns only $56,044. The 0.5% TER variation spelt a difference of $5K+ in returns.

To find out about an ETF’s TER, you can look it up at the ETF’s fact sheet or prospectus, or online on ETF screeners and Google/Yahoo Finance pages.

Consideration #4 – The Liquidity of the ETF

The liquidity of the ETF (or any other financial instrument) is the measurement of how quickly it can be transacted in the financial markets without affecting its price. For instance, if ETF A has a 10,000-unit buy queue at $1 and a 5,000-unit sell queue at $1.05, it is highly liquid, since the narrow price spread would make the buy/sell transactions easier. However, if ETF B has a 1,000-unit buy queue and a 500-unit sell queue at $1.00 and $1.50 respectively, then it is not so liquid or is illiquid.

Fortunately in a way, there are market makers (like the authorised participants that are responsible for the ETF creation and redemption processes with the ETF providers) who can facilitate some liquidity for the ETF. These market makers act as middlemen and will buy up the sell side and sell to the buy side, earning some profit along the way if feasible.

Consideration #5 – Tax 

Specifically tax from dividends. There are some ETFs whose dividends are subject to tax, like those based on foreign markets. Typically if you (as an individual) invest in a United States (U.S.) market ETF, and if you are not a U.S. person, a 30% withholding tax is imposed on the dividend. Meaning if an ETF is giving a 5% annual dividend yield, with the withholding tax, the effective yield is only 3.5%. 

Still, if you are still unsure about taxes and such, it is best to consult an accountant or tax expert (and I’m not one of them, apologies).

Putting Them All Together

The above five considerations are not exhaustive but I believe they are sufficient in your ETF selection for your investment portfolio. A holistic approach is needed; it is better to balance out the considerations and not to over-emphasize on one, like looking strictly at TER without regarding the index.

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