Building a long-term investment portfolio with ETFs is easier than ever. However, there are a couple of steps that are important for portfolio construction that can help you minimise your fees and thus maximise your returns.
We’re showing you how to choose ETFs based on key criteria — happy investing!
Determine your investment objectives
Before you choose ETFs, it's essential to understand your investment goals, risk tolerance, and time horizon. This means that you should have a good understanding of what you are actually willing to achieve with your portfolio: capital preservation? A target return? And by when?
A good way of understanding your objectives is by working with a financial advisor or filling out an investment questionnaire with a robo-adviser.
Also, you can use Standard’ Life’s or other investment questionnaires to determine your objectives if you’re planning to build the portfolio yourself. It will help broaden your perspective of different ETF investment strategies.
Pick individual ETFs
Once you understand how you want to construct your portfolio, you can continue to select your desired ETFs to achieve your chosen risk and return characteristics. There is a huge variety to choose from including VUSA, VWRL, VUKE, VWRA and ACWI.
There are many ETF screeners online, and for start we can recommend working with Morningstar’s tool, where you can not only see the Morningstar rating of the ETF but also if they are available on your local stock exchange. This is important because ETFs are subject to different local tax and financial regulations, which means that some ETFs you like may not be available in your respective jurisdiction.
- Consider the ETF's exposure
If you are selecting individual ETFs for your stock, bond and other asset allocation, it is essential that you analyse the underlying index or asset class on which the individual ETF is based.
The reason for this is that for an optimal portfolio allocation, you should strive for a well-diversified individual ETF that is also based on a widely followed index rather than one with a narrow industry or geographic focus.
Examples of broad equity indices are the MSCI Word or in local terms the S&P 500. As for bond incidences, again there are global bond indices available or local bond indices broken down by investment grade, corporate blinds and government bonds.
- Evaluate tracking error and tracking difference
Tracking error is a term which measures how closely an ETF matches the index performance.
Because ETFs are passive investment vehicles, you don’t want an ETF which diverges too much of the index performance, regardless of whether positive or negative.
Hence, try to choose ETFs which closely track the index returns, and thus exhibit minimal tracking errors and differences.
- Assess the ETF's size, spreads and trading volume
Illiquidity is a cost which is not directly visible to people, but it can be substantial. Illiquid and small ETFs sometimes exhibit excessive spreads, even if they are traded on a well-known exchange. Hence, ensure that your selected ETFs have a minimum level of assets, typically at least $10 million, to indicate sufficient investor interest and low spreads.
Also, check if the ETF trades in adequate volume daily, as higher trading volume implies better liquidity and tighter bid-ask spreads. And last but not least. Check the actual spread during live trading hours and the commissions your broker is charging for orders in your desired size.
- Compare expense ratios
ETFs tend to have much lower expense ratios compared to actively managed funds. Very competitive ETF expense ratios, meaning the cost of managing the ETF for a year, can be as low as 0.1% or 10 basis points.
As a result, it's still crucial to compare the fees associated with different ETFs to ensure you're selecting a cost-effective option.
- Review the ETF issuer
Choose ETFs backed by strong and reputable companies, just as you would with mutual funds. This can help minimise the risk of the ETF being liquidated due to a lack of investor interest.
- Be cautious of trendy ETFs
Unless you decide to invest based on a core-satellite approach, be cautious with investing too much of the equity portion of your portfolio into “trendy” sector ETFs.
The reason for this is not only that the sectors might be riskier or more volatile than broad indices, but also that the associated fees with such products tend to be higher.
Moreover, often there is not more than a name on the package and the bulk of the allocation is into liquid large caps, which are already dominating broad market incidences. Hence, you might pay a premium for example for an artificial intelligence ETF which is primarily allocated into Nvidia, Apple and Tesla stock, which make up a substantial amount of the Nasdaq-100 weight.
Avoid leveraged ETFs and short ETFs
One of the easiest ways to lose money is by investing in leveraged or short ETFs, in particular on single stocks. The reason for this is that leverage is calculated on a daily basis and compounds. As a result, if a stock loses say 10 per cent on day one and gains 10 per cent on day two, an investor in the stock would be nearly flat.
However, an investor in a say 2x leveraged ETF would lose 4%. ( 100 * 0.8 = 80 * 1.2 = 96 ). This was an example calculated over 2 consecutive days, but with around 250 trading days a year, even small fluctuations in a sideways market make leveraged ETFs a guaranteed way to lose money, mathematically!
As for non-leveraged short ETFs, the risks are similar: if a stock proceeds rising a few days in a row, the losses from the short ETF do not add to each other as if you were short the stock, but the daily performance compounds losses.
The only suitable use of leveraged and short ETFs is for short-term trading and experienced traders.
Monitor your portfolio regularly
Last but not least, even though you’re investing for the long term in a buy-and-hold or dollar-cost-averaging way, it's well advised to nevertheless keep track of your ETF investments on an ongoing basis.
The reason for this is that due to different performance over time, you might need to reallocate your portfolio to bring it back into line with your investment objectives and risk tolerance.
