The advantages of ETFs are clear to most of the investors out there. However, not everyone knows how to pick ETFs. In this article, I will share with you the 5 criteria I use to pick ETFs for my personal investment portfolio. Just to be clear, this article is NOT about which ETF theme to pick on (e.g. MSCI World or health care). The guide is more about how to pick ETFs when you are already clear about the ETF thematic.
For example, should you rather buy the Lyxor MSCI World UCITS ETF – Distributing or the iShares Core MSCI World UCITS ETF? Both replicate the same index, yet there are some crucial differences between them.
Total expense ratio
The total expense ratio (TER) is a key element in your decision to invest in an ETF. The TER is the metric that tells you how much it costs to run and operate an ETF. It is calculated by the sum of the asset under management of the ETF divided by the cost of running the ETF.
For example:
>> Cost = $2.000.000
>> AUM = §400.000.000
>> TER = 0.5%
- Index fees: ETF issuers have to pay licensing fees to companies such as S&P or MSCI in order to use their indexes and replicate them.
- Market maker fees: Those are the fees for the people or computers that are executing the buy and sell orders as well as the recalibrating of the ETFs when the weight of a specific stop is changing for example. These services are in-house for some issuers, while others use an external market maker, which can impact the
TER. - Trading fees: The brokerage fees incurred when buying and selling the shares that compose the ETF.
- Legal and auditing fees: In order to protect the interests of investors and to comply with the law ETF issuers needs to occur legal fees to guarantee continuous compliance.
- Operational expenses: ETF issuers, like any other company, have staff and offices that need to be compensated. Keep in mind though that the more an issuer operates different ETFs, the lower the operating expense per ETF will be. E.g. An issuer operating 10 ETFs might need ~10 people (1:1 ratio), full-time employees, while another issuer operating 100 ETF will need ~15 FTEs (100:15 ratio).
How TER is paid
The cost will be deducted directly from the dividends or the share price, so you may not realize that you are paying a high TER. ETF investors generally will never see this payment. This applies to ETFs that pay dividends, as well as to ETFs that reinvest dividends on your behalf (capitalizing). Unlike the platform and brokerage fees that appear on the statements, TER is softly deducted from your return. It is therefore up to you to keep a close eye on the minimum disclosure documents to see how much your ETF has cost you in the last year.
Replication strategy
Physical replication – Full replication
Physical replication is the classic method. If the ETF directly holds all the securities of the index directly, this is known as full replication.
Physical replication – Sampling or optimised sampling
The MSCI World Index is made of ~1600 constituents over 23 developed countries and 26 emerging markets. Each country has its own stock exchange so buying each of those securities one by one as well as recalibrating the index on a regular basis would cost lots of time and money. As a consequence, over time, practices to replicate indexes have evolved. In order to keep trading fees low, ETF issuers use optimized sampling to cover the index. Optimized sampling will use only 20-30% of the securities of the index in order to replicate the performance of the full index.
Synthetic replication
For indexes that are particularly difficult to replicate, ETF issuers will favor a synthetic replication. The ETF does not hold the security directly. Instead, the ETF holds a portfolio of liquid securities that is diversified and will buy and sell those securities in order to match the performance of the initial index. While counter-intuitive (you would not expect to hold Amazon stocks in a synthetic ETF covering the MSCI Indonesia), synthetic replication is in general yielding lower costs.
ETF issuers
In the same way that it can make sense to diversify your stockbrokers, I personally prefer to also diversify the ETFs issuers. Also, while the chance of an ETF issuer going bankrupt is fairly small (and even if an issuer goes bankrupt, the ownership of the stock does not belong to the issuer but to the investor anyhow). I still prefer to hold my ETFs spread over multiple issuers. There are 3 categories of issuers:
- Asset managers: Blackrock, Vanguard, Lyxor
- Banks: BNP Paribas, Deutsche Bank, Citigroup
- Insurances: Allianz
Liquidity
In order to ensure the highest degree of sellability, I will generally prefer buying the ETF on the exchange where the liquidity is at it’s highest.
Dividend allocation
Most securities, except maybe Tech or unprofitable companies will reward their shareholder with a dividend paid monthly, quarterly, half-yearly, or yearly. Some ETFs will be distributing the dividend directly to the holder while other ETFs will be using the dividend to buy additional shares of the ETF (capitalization/accumulate). ETFs of purely tech companies will not pay any dividend, simply because the underlying security does not pay any dividend and growth is probably enough to keep investors happy.
>> My opinion – not financial advice for sure – is that ETFs which reinvest the dividend are globally less taxed than ETFs which distribute the ETF (at least in my jurisdiction). My aim is, therefore, to accumulate capitalizing ETFs and when the day comes, convert capitalizing ETFs into distributing ETFs in order to live from passive income.
To put it short: Let’s imagine the following scenario, I want to invest in the MSCI World and I am hesitating between Lyxor MSCI World UCITS ETF – Distributing or the iShares Core MSCI World UCITS ETF.
| Lyxor MSCI World | iShares Core MSCI World | |
|---|---|---|
| TER | 0.3% | 0.30% |
| Replication | Synthetic | Physical |
| Issuer | Lyxor, belongs to Société Generale | Blackrock |
| Liquidity | ~6200 XETRA | ~91.000 XETRA |
| Dividend | Distributing | Distributing |
In the example above, I would go for the iShares Core MSCI World. Same TER, but more liquid, and I prefer physical replication in general. Also, Blackrock is a market leader of ETF worldwide, so I would tend to trust them more versus Lyxor.
>> In case two ETF issuers are ex-aequo, I will use a rotation.
Please keep in mind that this is not financial advice. I am merely documenting my journey to financial freedom.
