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Choosing the best ETFs: Five things smart investors check before buying

Exchange-traded funds, or ETFs, were designed as a simple tool for investors to access investment strategies. They quickly gained popularity due to their low cost, tax efficiency and ability to be easily bought and sold.

Today it’s common to find three or more similar ETFs, making it difficult to determine which product will work best in your portfolio. So what should you consider when evaluating an ETF? Here are five key questions that investors should consider before buying an ETF.

 

1.  How has the ETF you’re considering performed?

Passive ETFs aim to track specific indexes, such as the TSX or the Dow Jones Industrial Average. They do this by investing in exactly the same securities of the underlying index, or by owning a select number of securities that present characteristics similar to those of the index.

In this case, you might assume that a passive ETF, since it’s based on an index, will perform exactly the same as the index. But it’s not quite that simple. How successful the manager is will be measured by how well the ETF tracks the index; this is known as the tracking error.

You can evaluate a passive ETF’s tracking error using two metrics, the fund’s R-squared (R2) and beta. R-squared is a statistical measure that indicates how closely an ETF tracks an index benchmark. The closer the R-squared value to 1, the more tightly the ETF follows the ups and downs of the benchmark. Conversely, the closer the R-squared value to 0, the more the ETF trends up or down independent of the benchmark performance.

An ETF’s beta represents how closely the underlying volatility, or risk, of the fund aligns with the risk and volatility of the benchmark. A beta value near 1 indicates that the fund’s risk characteristics closely match those of the benchmark. A beta value of 0.9 indicates the fund has 10% less variability than the index benchmark, while a beta of 1.1 indicates the fund has 10% more variability.

While some ETFs are passive, others can be more active, looking to outperform. In that case, you could look at the excess return, which is the return achieved above and beyond an index, and the Sharpe ratio, which compares the returns of investment managers by making an adjustment for risk.

These are a few useful ways of calculating the difference in returns relative to an index and how much return you are getting for the amount of additional risk you’re taking on. Typically, you’re looking for the Sharpe ratio to be higher than 1.0, but it’s important to keep in mind that the Sharpe ratio should be evaluated relative to that of the benchmark. 

And, as always, remember that past performance is no guarantee of future performance.

2. How much will owning your ETF cost?

ETFs were designed to offer investors lower-cost investment strategies, but there are still expenses that you need to understand in order to get the results you want.

Management expense ratio
While it generally costs less to operate an ETF than a regular mutual fund, you still will be charged an MER to cover the management expenses. MERs tend to be higher for more complex or actively managed ETFs.

Bid-ask spread
When you’re trading ETF units, there’s a difference between the price that a buyer is willing to pay, the “bid,” and that a seller is willing to accept, the “ask.” Buyers, of course, will try to get a lower price, while sellers will try to get a higher price. The difference is the bid-ask spread. It will vary, depending on how popular your ETF is.

If you’re trying to buy or sell units in an ETF that follows the TSX, plenty of other investors will be interested, so there won’t be much difference between the buying and the selling price.

If you’re trying to buy or sell units in a more obscure ETF, such as a European bank stock’s ETF, there will be fewer buyers and sellers interested, and the spread will tend to be larger. The difference between what you paid for your units and what you can sell them for may cost you.

While ETFs are relatively low-cost, all of these expenses can eat into your potential profits. And if you trade often and if your ETFs are highly specialized, you may end up paying more than you expect.

 

3.What do you want your ETF to invest in?

Originally, ETFs were relatively simple, investing in well-known indexes. Today, however, ETFs offer access to a huge selection of investment markets. Now ETFs can allow you to participate in anything from Brazilian corporations to the global timber and forestry industry.

But just because you can invest in an ETF that follows a Canadian oil and gas index doesn’t mean you should. You want to select an ETF that fits into your overall investment strategy, and it’s important to remember that certain specialized ETFs (for example, ETFs that invest in physical commodities) may have different structures, rules and tax implications that you need to be aware of.

Understanding your goals and risk tolerance and having a clear strategy for your portfolio will help you choose which ETFs suit your needs. You also need to assess your willingness to learn about different types of ETFs and keep track of the markets they reflect.

 

4. Do you want a passive or active ETF?

Originally, ETFs were designed to be passive. They followed the index – up, down, flat – and wherever the markets went, your money went too. That could work well when markets are going up, although you might miss out on the very best opportunities. But when markets fall, passive ETFs will follow them all the way down.

An actively managed ETF seeks to outperform, by emphasizing parts of an index that can exploit the best opportunities in up markets and mitigate the worst risks when markets drop. It seeks to combine the best features of an ETF – choice, simplicity and low cost – with the attractions of active management – the potential for outperformance and reduced risk. It may also cost a little more.

 

5. Who is the fund provider?

Two questions you should ask before investing is who is providing your ETF, and what do they bring to the table? That’s particularly important if you’re looking for an actively managed ETF.

Active managers of ETFs should have some of the following attributes:

  • an international network of researchers sharing information
  • access to deep information about markets and corporations around the world
  • sophisticated analysis of market behaviour going back decades
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