In our view, there are three main considerations for investors, when choosing an ETF:
1 - The benchmark index 2 - the fund's size 3 - the structure of the fund.
Let's start with the index. This might seem an easy step, but there are more than 1.5 million
indices out there. Investors should think about the index that allows them to
better express their portfolio views. For example, to gain exposure to European equities
the EuroStoxx 50 is a good solution as it covers 50 of continental Europe's largest companies
(by market capitalisation). But if you want to increase diversification, the MSCI Europe
might be more suitable, as it is made up of over 440 constituents. Meanwhile, the MSCI
EMU allows you to remove exposure to the UK, if you want to concentrate on the Continent.
The Assets Under Management of an ETF is known as the AUM and it is important in relation
to the efficiency of the fund. Passive investing or index investing is a scale business
in that large funds help keep costs down for investors, as economies of scale kick in and
the fixed costs of running the fund can be minimised. In addition, one of the most important
aspects of ETFs is their liquidity. Liquidity simply means how easily an asset can be bought
or sold, and how quickly the proceeds of the sale can be converted into cash. Liquidity
is important as investors want to be able to buy or sell investments quickly and cheaply
during the stock exchange's opening hours. The larger a fund is, the more liquidity it
will have, leading to narrower spreads i.e. a smaller difference between the price at
which you can sell the fund and the price at which you can buy it. Larger ETFs, in
general, have lower trading costs.
Ultimately, it's about the tracking experience of the investor. Indices are intellectual
objects that don't exist. When using a financial instrument to gain access to them, costs will
have to be paid and there may therefore be a slight difference between the return of
the index and the return of the fund. Minimising those differences, those drags, by keeping costs
down and choosing an established and experienced ETF manager is key.
In Europe, ETFs can replicate an index by purchasing all or a subset of the index constituents,
such as shares for a FTSE 100 ETF. This structure is called physical replication. An investment
management company can also deliver the index performance through a different set up known
as synthetic replication. This is slightly more complex to understand, instead of holding
the underlying shares, these ETFs use financial engineering to achieve the desired results.
Synthetic ETFs use derivatives such as swaps to track the underlying index.
The two set ups have benefits and limitations. For example, the physical set up is transparent,
safe and easy to understand, but doesn't work for certain indices, for example commodities.
The synthetic set up is very useful in those cases, but there can be some additional risks
because of its use of derivatives.
To wrap up: there is an amazing breadth of opportunities in the ETF space, and due diligence
is important. Today, we have covered three key aspects investors should always consider.