Chapter 3: How to choose an Exchange Traded Fund

If you’ve made the decision to invest in an exchange traded fund, the next step is to decide on a fund that’s right for you. But, with more and more ETFs to choose from, how do you narrow it down? Here are a few things you may want to consider before investing in an ETF.

The Cost of an ETF 

Although typically considered a low-cost investment, ETFs do charges fees and some are more expensive than others. Generally, ETFs will carry a brokerage fee and management fee. An additional cost charged by the broker, a brokerage fee applies when you buy or sell units in an ETF and are typically a flat fee but can increase depending on the size of your trade.

Management fees, on the other hand, are charged annually and by the fund provider. For a rough idea of what you should expect to pay, we looked at all the ETFs on etfwatch and averaged out the management fees, and at the time of writing the average came to 0.49%. However, fees can vary depending on the market, region, or industry the fund is tracking. For example, typically the management fee for ETFs tracking Australian assets is lower than those tracking international assets.

While fees are important, they should not be the only thing you consider before investing in an ETF.

Need a refresher on ETFs? Check out this helpful article.

Bull and Bear figures with ETF label in background
Always make sure you thoroughly research ETFs before deciding to invest.  Source: Gopixa (shutterstock)

Liquidity and size  

Another aspect you should consider is liquidity. Liquidity refers to how easily you can buy and sell your assets and access your funds.  Property is a good example of an investment with low liquidity, as it can take months, even years to sell a property and retrieve your funds. Shares, on the other hand, are considered by most as having high liquidity. Due to the high volume of activity on the share market, this makes stocks relatively easy to buy and sell.  As ETFs are traded on the stock market they are also typically thought of as a high-liquid asset, but it does depend on the fund itself.

One way to determine the liquidity of a fund is through its size. The more funds under management suggests the volume of trading will be higher. There will be more buyers in the market when it comes time to sell and more sellers in the market if you are looking to buy. Stockspot, an online investment adviser, considers ETFs with more than AU$25 million in funds under management to be of a decent size.

Depending on your investment strategy, the ability to buy and sell easily can be important and something to consider when choosing an ETF.

Counterparty risk

Generally, ETFs can be split into two types: physical and synthetic. A physical ETF is a fund that owns the assets it tracks. Whereas, a synthetic ETF relies upon derivatives to achieve its investment objective. Instead of owning the physical assets, derivatives are agreements between the ETF provider and a counterparty, typically an investment bank, to pay the ETF the return of the index. This leaves synthetic ETFs open to the risk that the counterparty will not honor their contractual obligations i.e. you may not receive your returns.  Counterparty risk should be considered when investing in a synthetic ETF.

Diversification

One of the benefits of an exchange traded fund is the ability to invest broadly across different companies, sectors and even countries. However, some ETFs are more diverse than others. Before selecting an ETF, it’s wise to look at exactly what the fund is tracking and how the fund is constructed. For example, investing in an ETF tracking the ASX 200 will likely be weighted heavily in the financials and materials sectors.  

ASX 200 Sector Breakdown (%)
Financials 29.26
Materials 18.02
Health Care 9.39
Industrials 8.2
Real Estate 7.44
Consumer Discretionary 7.12
Energy 6.22
Consumer Staples 5.59
Information Technology 3.43
Telecommunication Services 3.25
Utilities 2.08

Source: ASX 200 List

Found this chapter outside of the Ultimate Guide to ETFs? Check out the full guide!

Before you invest in an ETF

Each investor will have their own interest and strategy which will change what they are looking for in an ETF. Therefore, the above points are just some of considerations you can make to help narrow down an ETF that’s right for you.  If you’re keen to start comparing the ETFs, Canstar can help.

Deciding on any product to invest in should not be taken lightly. You should always consider the risks involved, carefully read the PDS and conduct your own research.

Cover image: Panchenko Vladimir (shutterstock) 

If you’re comparing Online Share Trading companies, the comparison table below displays some of the companies available on Canstar’s database with links to the company’s website. The information displayed is based on an average of 6 trades per month. Please note the table is sorted by Star Rating (highest to lowest) followed by provider name (alphabetical). Use Canstar’s Online Share Trading comparison selector to view a wider range of Online Share Trading companies.

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