Introduction

Exchange-traded funds (ETFs) are a great way to build diversified portfolios. As ETFs have grown in popularity, the supply of ETFs has grown as well. When it comes to investing in a specific index, such as the MSCI World Index or S&P 500, investors now have multiple options to choose from. Each ETF offers exposure to the same index but may have different characteristics, costs, and underlying strategies. Choosing which ETF to pick among the plethora of options can be quite overwhelming. To help you make an informed decision, we have listed the key criteria below.

1. Tracking Error

Tracking error is a critical metric to evaluate when choosing an ETF. It measures how closely the ETF's returns match those of the underlying index, for example, the MSCI World Index. A lower tracking error indicates that the ETF closely mirrors the index's performance. However, keep in mind that tracking error can vary over time due to factors like management fees, trading costs, and replication methods.

2. Expense Ratio

The expense ratio represents the annual cost of owning an ETF as a percentage of your investment. Lower expense ratios are generally more favorable, as they reduce the drag on your returns over time. When comparing multiple ETFs, opt for the one with the lowest expense ratio, provided that other factors align with your investment goals.

3. Liquidity and Trading Volume

Liquidity is crucial when trading ETFs. Higher liquidity typically results in narrower bid-ask spreads, reducing trading costs. It is advisable to choose an ETF with sufficient trading volume to ensure ease of buying and selling shares. Adequate liquidity also helps mitigate the risk of price distortions, which can occur in thinly traded ETFs.
Liquidity is a very abstract concept. Although there are several metrics to measure liquidity, the easiest way is to look at the average daily trading volume of the given ETF.

4. Replication Method

ETFs can replicate the performance of the MSCI World Index through two primary methods: physical replication and synthetic replication. Physical replication involves owning the actual securities in the index, while synthetic replication uses derivatives to track index performance. Physical replication carries less risk as the underlying securities are owned outright by the ETF vehicle. Synthetic replication is sometimes a more cost-efficient option. Synthetic replication uses derivative contracts, typically with an investment bank, to reflect the returns of a given index. This results in counterparty risk.

5. Dividend Yield and Distribution Policy

If you're looking for income, consider the ETF's dividend yield and distribution policy. Some ETFs may pay dividends (distributing ETFs), while others may reinvest them (accumulating ETFs). The choice between accumulating and distributing ETFs is subjective and depends on your investment strategy. Distributing ETFs are more suitable if you want to pay part of your living expenses out of your dividend income. Accumulating ETFs are more suitable if you prefer to re-invest dividends automatically into the same ETF rather than receiving the dividend income in cash.

6. Holdings

Yes, I know, when comparing different ETFs linked to the same index, the holdings should be exactly the same. However, this is not always the case. For instance, the Vanguard S&P 500 ETF invests in the S&P 500, with as its target to have the exact same holdings as the index. In contrast, the Invesco S&P 500 Equal Weight ETF invests in all shares at roughly equal weights. Another S&P 500 ETF, iShares S&P 500 Value ETF, invests in S&P 500 companies according to a ‘value’ filter.

At the time of writing, the Vanguard S&P 500 ETF holds 7.33% of Apple, the Invesco S&P 500 Equal Weight ETF holds 0.20% of Apple, and the iShares S&P 500 Value ETF holds, at the time of writing, 0%. The name might not always reveal these nuances to you in a way you are familiar with. This is why it is good to double-check the holdings of the ETF before you invest.

7. Tax Efficiency

Tax efficiency is a crucial consideration for long-term investors. ETFs are generally tax-efficient vehicles, but differences can exist among them. Factors like portfolio turnover and capital gains distribution can impact your tax liability. Look for ETFs that minimize these tax consequences to optimize your after-tax returns.

8. Provider Reputation

Choose ETFs offered by providers with a solid track record of managing funds effectively and transparently. Some of the biggest names in the business are Blackrock, Vanguard, State Street. Large, established providers with a long and clean track record are less likely to fail. In addition, the leading providers often offer better index tracking and risk management at a lower cost. Size matters, also for ETF managers.

Where to compare ETFs

My favorite tool to compare ETF metrics is ETF Database, etfdb.com. It allows you to select a certain index or theme, after which you see a list of all the ETFs linked to this index or theme. You can then sort and filter the results based on the criteria we have discussed above. ETF Database has a free plan, and a paid plan in which you see more in-depth information.

In addition to ETF Database, the best place to find information is the website of the ETF Manager. The webpage of the specific ETF usually contains a very extensive overview of all the metrics discussed above and more.

Conclusion

Selecting the right ETF involves careful consideration of various factors, including tracking error, expense ratio, liquidity, replication method, holdings, dividend yield, tax efficiency, and provider reputation. Take the time to assess these factors in alignment with your investment goals. ETF Database can be a great tool to efficiently review your ETF options. Remember to carefully review the website of the specific ETF as well.