Exchange-traded funds (ETFs) are index funds (mutual funds that track various stock market indexes) that trade like stocks. As such, ETFs have all the benefits that index funds offer and more.
Its booming popularity has prompted many investors – including the pros – to take notice of these funds. According to WSJ, money invested in ETFs has more than quintupled over the past five years and the number of existing ETFs has skyrocketed at the same pace. This means that investors now have hundreds of ETFs to choose from.
While this is still a relatively small number compared to the thousands of mutual funds that exist, it is still a lot of growth and there are hundreds more on the way.
But while ETFs have grown to encompass a huge breadth of investment choices, they aren’t all equal in quality. In fact, a flip side to the phenomenal growth in ETFs is that it increases the risk that some will be liquidated due to a lack of investor interested. How can you find a profitable ETF to fit your investment portfolio? What are the metrics to look out for? Read on to find out.
1) Monthly Trading Volume
Trading volume occurs as a direct result of demand and supply. In general, lower-risk securities (such as bonds) are more freely traded and therefore have higher trading volume and liquidity.
The more actively-traded a particular security is, the most liquid it is. Therefore, ETFs that invest in actively-traded securities will be more liquid than those that do not, indicating a lower liquidity risk. Liquidity risk arises from situations in which a party interested in trading an asset is unable to do so because nobody in the market wants to trade for that asset.
2) Country Or Region
The main attraction of ETF investing is the level of diversification it offers. It provides exposure to an impressive range of markets, sectors, commodities, hedge funds and bonds. Volatility is hence reduced and ETF investors lower the odds that all their investments will lose at once.
However, an investor is exposed to foreign exchange risk if he or she buys an ETF from a market whose currency is different from his or her own. Some ETFs may also trade in a currency that is different from that of the underlying assets, so it pays to first look at the country or region in which an ETF is vested in.
ETFs that are focused on a single industry sector tends to be riskier. For example, REIT ETFs focus specifically on the real estate sector. This exposes investors to higher sector-specific risks, since REIT performance is tied directly to real estate values. Despite this, REIT ETFs still offer a considerable amount of diversification within the real estate sector (e.g. retail, residential, office, industrial, healthcare, hotels and resorts, etc), despite being limited to just one sector.
4) Assets Under Management (AUM)
AUM is the total market value of assets that an investment company or financial institution manages on behalf of investors. As a general rule, investors should be wary of any fund with less than US$50 million in AUM. Doing so may reduce your chances of running into a mismanaged or unprofitable fund, and lower your liquidity risk.
However, AUM isn’t the be-all and end-all approach for picking ETFs. There are literally hundreds of low AUM ETFs that are healthy year-round and using the US$50 million cut-off point could rule out a number of funds that may turn out to be solid growers over time.
5) ETF Structure
ETFs broadly have two structures: direct replication (cash-based) or synthetic replication. Cash-based ETFs invest in securities that replicate or represent the composition of the index it tracks. Meanwhile, a synthetic uses swap contracts to enter into an agreement with one or more counterparties who promise to pay the return on the index to the fund. In doing so, the returns depend on the counterparty being able to honour its commitment.
Proponents of synthetic ETFs say they do a more accurate job of tracking indexes. While critics say synthetic ETF investors face counterparty risk, are not transparent and may mislead investors. However, this counterparty risk can be reduced by collateralising the swap agreements.
Synthetic ETFs are common on the Hong Kong Stock Exchange (HKSE), which differentiates them from traditional ETFs by placing an “X” in front of their names. To mitigate risk, Hong Kong’s financial regulators have subjected synthetic ETFs to greater scrutiny and imposed additional requirements on the institutions that issue them.
6) Expense Ratio
Expense ratios are an extremely important factor to watch as they directly affect your financial returns. In general, ETFs are attractive to investors for their low fees compared to mutual funds. For instance, the SPDR STI ETF, Singapore’s first locally created ETF has an annual expense ratio of just 0.30%, and the Vanguard REIT ETF has an expense ratio of just 0.12%. On average, most ETFs carry an expense ratio of 0.44%.
The bottom line for investors looking for financial returns is to first understand the expenses and risks associated with any specific ETF or investments that they are considering, as well as the level of income to expect and tax considerations in order to maximise investment gains.
Also, find out if REITs or ETFs are more suitable for your overall investment portfolio!