Aug. 21, 2009
In part 1 of our series we talked about the right index to chose when investing in ETFs. The question now would be which are the right product and the right fund provider.
The global market leader in ETFs is iShares, which is still owned by Barclays but would soon be sold. But there are many other companies that have ETFs on offer. Deutsche Bank offers xtracker, Credit Suisse offers Xmtch, and UBS has its own ETF series. In the US there are besides iShares, State Street, Vanguard and Powershares, many more such firms. If you are interested: here is a list of the globally leading ETF providers by assets under management (as well as the biggest ETFs and the fastest growing funds).
For any of the big indices you can chose from different providers. In some cases, like the leading European bluechip index DJ Eurostoxx50, there are more than a dozen providers. It is quite complex how a fund firm tries to mirror an index with an ETF. And it does not make a lot of sense to discuss these technical details in a short article (we will publish a report on this topic at some point in 2009). But here are some quick rules how to choose the right provider and the right product:
Rule 1: Have a look at the historic performance of the fund. Check whether the fund has on average over-performed or under-performed as compared to its basic index. There are actually some funds that over-perform compared to their basic index relatively consistently. Go for them.
Rule 2: Check the tracking error. This number shows how accurately a fund tracks its underlying index. Tracking error should normally be lower than 1% per year.
Rule 3: Check the TER. This is the Total Expense Ratio. If you can’t find it in the fund’s fact-sheet go to the website of Morningstar or any other fund information aggregator. The TER gives a pretty good impression on how expensive a fund is. ETFs vary depending on their size and how special the underlying fund is. But there are often significant differences for the same underlying index.
Rule 3: Go for the big boys. A fund with a high amount of assets under management is usually more liquid than a smaller fund. Hence, the spread on the stock market is likely smaller. You will also find this number in the fund fact-sheet.
Rule 4: In most cases, go for “full replication ETFs”. There are basically two ways an ETF can be constructed: One is “full replication”, which means the ETF actually contains all securities that are part of the underlying index. The other methodology is “synthetic replication” of the index, involving so-called swaps, a form of derivative financial instruments. Swaps involve some counter party risk although it might be strictly limited by the rules that govern a fund. In some cases synthetic replication funds track their underlying index more precisely and cheaply (which will reflect in the lower tracking error and lower TER).
Rule 5: Avoid leveraged ETFs unless you have some very specific trading objectives and manage your risk carefully. There are now more and more ETFs that use leverage. There are even leveraged short ETFs. These instruments might make sense for a short-term investor who, for instance, wants to hedge some of his other investments. For the inexperienced private investor as well as for someone with a long-term outlook these usually much more expensive products make absolutely no sense.
When you look at different ETFs you have to weigh rules 1-4. There might be the case where one fund is less expensive but uses swaps. Another fund might be more expensive, uses full replication and have a bigger tracking error but has historically a better performance than the underlying index. Your ultimate choice depends on your personal preferences and your risk profile.