How to choose the right ETF

Find out the important things to consider before investing in an ETF.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results.

ETF due diligence

ETFs are a fast-growing global industry with over $3 trillion in assets under management. And with investors increasingly attracted to their low cost and transparent nature, the global boom shows no sign of slowing down.

However, with some 6000 ETFs listed on exchanges worldwide, how do you decide which ones are right for your portfolio? Watch Ursula Marchioni, chief strategist for EMEA at iShares by BlackRock, discuss three aspects you should always consider.

ETF investments: three key considerations

The benchmark index 

Selecting which index to track might seem like an easy decision, but bear in mind there are more than 1.5 million indices globally. Which will give your portfolio the right exposure?

For example, an ETF tracking the Euro Stoxx 50 will provide exposure to 50 of the continent’s largest companies. However, if you want even broader diversification, then the MSCI Europe has more than 440 constituents.

You may also want to avoid certain exposures, say to the performance of UK stocks if the economic forecasts are disappointing. By investing in an ETF tracking the MSCI EMU, you can ensure you only have access to equities listed in continental Europe.

The ETF’s size

It’s important to consider the size of an ETF – that is the value of its assets under management (AUM) – as it affects the efficiency of the fund and its associated costs.

In general, larger ETFs have lower trading costs. This is because they’re usually more liquid, enabling you to buy and sell shares quickly and cheaply if the market is open, and easily convert the proceeds into cash.

And the more liquid the ETF, the narrower the spread, meaning there’s a smaller difference between the price at which you can buy and sell. By keeping trading costs to a minimum, it’s easier for larger ETFs to post similar returns to their benchmark.

The structure of an ETF

To replicate the performance of an index, ETFs will be structured in one of two ways: physically or synthetically.

Physical ETFs replicate an index by holding shares in all – or a subset of – its constituents. For example, a FTSE-tracking ETF might hold shares in all of the FTSE 100’s listed companies. Synthetic ETFs are more complex, and use financial derivatives such as swaps to track an index.

Physical replication is transparent, safe and easy to understand, but isn’t suitable for tracking perishable commodities. Synthetic ETFs are a great alternative for these markets, but they involve additional risk due to the use of derivatives.

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