ETFs: What they are and how to pick the right one for you

Like Warren Buffett, one of the most successful investors of all time, I am a big fan of exchange-traded funds (ETFs) as an investment vehicle. They typically provide low-cost, highly liquid, highly diversified and immediate exposure to specific asset classes and can be traded on the ASX just like a share.

The ETF marketplace is becoming more crowded and, at the time of writing this, there were almost 200 exchange-traded products listed on the ASX, representing more than $45 billion of assets under management. That’s twice as many options as there were just five years ago.

On one hand, more ETF providers competing with each other is a good thing, because it helps put pressure on fees, but on the other hand it’s also more complicated because there’s more choice. The paradox of choice … how do you choose when there’s so many options?

The very first consideration when evaluating ETFs should be what asset classes you want to introduce into your portfolio.

This will depend on your needs, appetite for risk and any weaknesses you may have in your overall investment mix. For example, if you’re already heavily invested in Australian shares and property already, perhaps you want to use ETF investments to broaden your portfolio and invest in global property or emerging markets overseas.

Once you know what asset classes you’re interested in, you can take a closer look at what’s on offer in those categories. ETFs can vary in a number of important ways and when comparing them you should consider a range of factors including:

Cost

Issuers have to disclose the MER (management expense ratio) on each ETF. This is not a fee you get a bill for, but it’s borne by the ETF and it’ll be reflected in the price you pay.

In addition to the MER, ETFs are also required to separately disclose their net transactional and operational costs. These are the costs incurred by the funds for things like brokerage charges (for buying and selling the assets held by the ETF) and foreign exchange associated with the trading activities of the funds. As these costs are paid out of the assets of the ETF, they will be ultimately reflected in the ETF’s price.

These costs are typically buried in the ETF’s product disclosure statement but it’s worth taking the time to hunt them out to really understand the overall cost position of the fund. Of course, an ETF might not be the best for your purposes just because it’s the cheapest – it’s only one part of the analysis.

Liquidity

An ETF is like a wrapper around a lot of assets, and it’s important to understand the assets you’ll be buying inside the wrapper.

Assets can be very liquid (that is, they can be bought or sold easily at market price) or illiquid (where it can be harder to find a buyer/seller as less liquid assets don’t trade as often), so you ideally want not only the ETF to have high levels of liquidity, but also the underlying holdings within the ETF to be liquid too.

If not, then it could affect the price you sell the ETF for, which increases your investment risk through potentially lower performance.

Track record of the ETF and its issuer

Most of Australia’s ETF issuers are large and well established, have decent processes in place and have products that are commercially viable and acceptable. Larger ETFs are preferred as a general rule because once a fund reaches critical mass, there is less risk of them increasing their fees to cover costs or potentially even closing down and returning investor funds.

The ASX produces a monthly report on investment products including ETFs that can be quite helpful in considering the investment landscape. ETFs can be a great investment tool, but with so many options out there it pays to looks closely at what you’re investing in.

Have you ever looked into ETFs? Does it seem like a reasonable investment option for you?