Here’s how we select the best ETFs (and how you can too)

This is a republished article from our Sponsor: FSMOne.com

Check out FSMOne.com ETF Focus List: A comprehensive list of outstanding ETF selected by their internal research team for you. Find Out More Here.

With so many factors to consider before selecting an ETF, what exactly should investors be looking at? Read on to find out more about the criteria we use to select the ETFs for our ETF Focus List.

ETFs for each category are ranked based on quantitative criteria such as expense ratio, liquidity, tracking difference and assets under management.
Besides quantitative criteria, qualitative factors, such as the choice of index, structure and replication method, are also taken into account.
Keep a lookout for our ETF Focus List 2019, which will be released within the next few weeks.

Choosing the right ETF can make the difference between investment success and mediocrity. That is why we have formulated our very own ETF Focus List that is based on our in-house selection methodology, with the goal of bringing you the best ETFs for every equity and fixed income market across the globe.

The ETFs on our Focus List are selected based on a set of quantitative and qualitative criteria. To start things off, the quantitative factors (expense ratio, liquidity, tracking difference and assets under management) are given weightages based on their relative importance. The ETFs for each market are then scored and ranked based on their composite scores.

After the quantitative assessment has been made, the ETFs are further evaluated by looking into their qualitative attributes, such as its underlying index, structure and replication method. As we take into account qualitative factors, the highest-scoring ETF based on our quantitative assessment may not necessarily be the ETF that makes its way onto our Focus List.

It is also important to keep in mind that although the ETFs chosen using our selection methodology do not guarantee superior returns, they do, however, have an edge over their peers based on our selection methodology. Here’s the low-down on how we select the best ETFs for our Focus List.

Expense ratio

The expense ratio is what investors pay annually, to cover for the various operating expenses and management of the ETF, such as management fees, administration costs, custodian costs, as well as audit and legal fees. They are expressed as a percentage of an ETF’s average net assets.

Needless to say, the lower the expense ratio, the higher the total return. Thus, expense ratio is one of the most important criteria in our selection process. Table 1 illustrates the impact expense ratios have on returns using a hypothetical investment of USD 10,000 compounded at 10% annually over the course of 5 years.

Table 1: Higher expense ratios can significantly lower returns over the long run

Expense Ratio	0%	0.5%	1%	1.5%	2%
Year 0	$10,000	$10,000	$10,000	$10,000	$10,000
Year 1	$11,000	$10,950	$10,900	$10,850	$10,800
Year 2	$12,100	$11,990	$11,881	$11,772	$11,664
Year 3	$13,310	$13,129	$12,950	$12,773	$12,597
Year 4	$14,641	$14,377	$14,116	$13,859	$13,605
Year 5	$16,105	$15,742	$15,386	$15,037	$14,693
Impact On Returns ($)	-$0	-$363	-$719	-$1,069	-$1,412
Impact On Returns (%)	-0%	-2.25%	-4.46%	-6.64%	-8.77%
Source: iFAST Compilations Data in USD Terms

If you had invested USD 10,000 in an ETF with a 0.5% expense ratio, the value of your portfolio after 5 years would be USD 15,742 (2.25% less than an ETF with a 0% expense ratio). A similar investment in an ETF with a 1.5% expense ratio will only be worth USD 15,036 (that’s 6.64% less than an ETF which has a 0% expense ratio). As the example above illustrates, even a small difference in expense ratios can significantly lower your returns over the long run.

Liquidity

Liquidity is a measure of how easy or difficult it is to buy or sell an asset quickly without affecting its price. Trading ETFs with high liquidity is advantageous as it allows investors to enter or exit positions swiftly, often at more favourable prices compared to ETFs with lower liquidity.

The total liquidity of an ETF is determined by its trading volume (secondary liquidity) and the liquidity of its underlying securities (primary liquidity). However, as most of us do not trade tens of thousands of ETF shares at any one time, primary liquidity is a less relevant measure in the context of most retail investors. As such, we consider mainly secondary liquidity in our analysis.

Our assessment of an ETF’s secondary liquidity takes into account two measures, namely the 90-day average daily volume and bid-ask spreads. Higher average daily volume and tighter bid-ask spreads are desirable as they point to a robust secondary market for a particular ETF.

Tracking difference

Tracking difference is the difference between an ETF’s performance and the performance of its underlying index. Tracking difference is often negative, meaning the ETF underperforms the index. There are several possible causes of tracking difference, the most common of which is expenses.

In theory, if an ETF has an expense ratio of 0.25%, we should expect the tracking difference to be negative 0.25%, as the total return investors receive would have to be reduced by the costs of managing the ETF. In reality, however, the tracking difference can be higher or lower due to other factors such as cash drag, representative sampling and securities lending.

A small tracking difference is desirable as it ensures investors are paying to get identical exposure as the underlying index. As part of our selection methodology, we only select ETFs with an established track record of at least 3 years. However, exceptions are made in cases where there is a lack of products.

Assets under management

Assets under management (AUM) is a measure of the total market value of assets an ETF holds. ETFs with large AUM have certain cost benefits. As the AUM of an ETF grows, operating expenses are spread over a larger asset base, thus reducing the total expense ratio. An ETF’s AUM is also indicative of its liquidity. ETFs with larger AUM tend to have higher trading volumes on average and are more liquid compared to their smaller AUM counterparts.

Lastly, AUM also gives investors clues on the strength of the issuer, and consequently, whether the ETF is at risk of closure. Imagine paying commissions fees to invest in an ETF only to be told shortly that it will be closed. Hence, we prefer ETFs with higher AUMs as they generally carry a lower risk of closure.

Qualitative criteria

In order to make a holistic assessment, we also take into account a list of qualitative criteria in addition to the quantitative criteria mentioned above. The qualitative criteria, along with their respective implications are listed in Table 2 below.

Table 2: ETF qualitative selection criteria

Qualitative criteria	Reasoning
Choice of index	The underlying index should be a good representation of the market/sector the ETF is intended to track.
Structure	ETFs can be classified as physical or synthetic, depending on the type of underlying investment.  A physical ETF replicates the benchmark return by holding either all or a representative sample of its underlying securities. Synthetic ETFs makes use of derivatives such as swaps to replicate the return of an index.  Physical ETFs are preferred over synthetic ETFs as investors are not exposed to counterparty risk.
Replication method*	Physical ETFs can be either fully or partially replicating. Fully replicating ETFs are ones that hold all the index constituents. If an ETF holds only a sample of the index constituents, it is said to be partially replicating.  Full replication is preferred over partial replication as it generally produces better tracking. Partially replicating ETFs may be considered in cases where partial replication yields more benefits e.g bond ETFs.
ETF trading currency	SGD or hard currency ETFs are preferred so as to minimise currency risk.
Exchange listed	ETFs listed on exchanges with the same opening hours as its underlying securities are preferred because it facilitates price discovery and allows ETFs to be priced more efficiently.
Source: Vanguard, Blackrock, iFAST Compilations  *Applies to physical ETFs only

Exciting updates coming your way

Our goal is to help you invest globally and profitably. By that very nature, we are committed to bring you only the best ETFs through our ETF Focus List. Investors can be assured that we will continue to monitor the ETF space closely, and make changes to our selection methodology whenever necessary.

In just a few weeks’ time, we will be releasing the 2019 edition of our ETF Focus List. Using our selection methodology, we have carefully curated a total of 40 ETFs for our Focus List this year. To better help investors construct their portfolios, we’re also introducing a brand new category ‘Tactical Plays’ that features our best ETF investment ideas. There are plenty more exciting changes in store for you, so be sure to keep a lookout for our ETF Focus List 2019.

Check out FSMOne.com ETF Focus List: A comprehensive list of outstanding ETF selected by their internal research team for you. Find Out More Here.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

There is no ads to display, Please add some