When starting on the journey of index fund investing, choosing an ETF may look confusing due to:
- Thousands of ETFs to choose from;
- New concepts to get acquainted with: Replication, Tracking error, Distribution type;
- Lots of acronyms: TER, ISIN, NAV, KIID;
Choosing an ETFs does not have to be complex. Below is my process for choosing one.
1. Decide the type of asset class you want to track through an ETF
Are you looking for an ETF that tracks US stocks or Global stocks? You usually decide about this when doing asset allocation. This step alone narrows down the amount of possible ETFs from thousands to dozens.
2. Find the ETFs that are within the asset class you determined in the previous step
justETF’s screener is a convenient way to do that.
3. Describe the resulting ETFs according to your decision criteria
The criteria used depends on your needs/preferences as an investor. Below I listed the criteria I use to compare ETFs. You may use some criteria to filter for ETFs on justETF’s screener and further narrow down the amount of ETFs you have to compare.
- TER (Total Expense Ratio) – I want to minimize fees since they affect returns;
- Fund size – I prefer larger funds as they seem safer;
- Replication Type – I prefer full (physical) replicated or sampled funds.
- Trading currency – I prefer to trade in EUR to minimize conversion fees.
- Domicile/Tax Status – I prefer funds domiciled in Ireland (to minimize taxes) with proper “reporting” status for my country of residence (to simplify taxes).
- Distribution policy – Accumulating or distributing. The choice here really depends on the specific tax situation of your country. In many European countries accumulating ETFs are more advantageous. But in some countries both have a similar tax treatment.
- Trading costs – These affect returns and should be minimized. Some brokers charge higher/lower fees on some ETFs.
- Index used – I try to understand if the composition of index (e.g. S&P 500, MSCI World, FTSE 1000) matches with my desired asset class and does not overlap with other components of my asset allocation.
- Returns (including dividends) – Past performance is not a reliable indication of future performance. But I like to have a general understanding of how the fund has performed since inception specially when comparing alternatives.
- Tracking difference/tracking error – This is an indication of how well the fund tracks the index.
- Trading volume – The more a fund is traded the easier it will be to buy/sell it and (hopefully) the bid-ask spread will be lower. This often influences more the particularly exchange I use for the ETF though.
Most of this information can be found in a decent ETF screener. Sometimes you’ll have to use multiple screeners to find all this info – I use justETF and TrackInsight. Occasionally you might have to look into the KIID or Prospectus to get the info you need.
4. Choose an ETF based on the criteria described above
You may not find an ETF that scores perfectly on all your criteria. You may have to consider some criteria more important that other. But the decision criteria will help you focus on the aspects that matter the most to you.