ABCs of Choosing An ETF

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With more than 50 exchange-traded funds (ETFs) listed on the Singapore stock market, how can we pick the most suitable ETF? This is a follow-up from our previous article on the types of ETFs available. Here, we share five considerations when selecting the best ETF for yourself.

A. The type of ETF

Firstly, ask yourself what is the type of ETF you wish to invest in. Do you want to diversify your holdings across the best dividend stocks listed in the region? Or would you rather diversify across the big local companies? Your investing preference would determine the theme for your ETF. You can check out our earlier article here to understand the various types of ETFs available on the Singapore stock market.

B. Tracking error

Tracking error is the difference between the performance of an ETF and its underlying index. Various factors cause this difference. For instance, the cost of buying and selling of securities are charged to the ETF, and this expense eats into the ETF’s performance relative to the underlying index that it tracks. Sometimes, dividends that are received, but not yet distributed to investors may cause tracking error as well.

Try to choose ETFs with a low tracking error. This criterion ensures that the ETF tracks the underlying index as closely as possible, giving us the closest possible return of the underlying index. Look for the tracking error disclosed in the ETF’s prospectus or fact sheet.

C. Expense ratio

The expense ratio is the annual fee that ETFs charge their unitholders. The fee includes costs such as administrative, compliance, distribution, management, and other related expenses. The expense ratio can be found in an ETF’s prospectus. For example, the SPDR STI ETF (SGX: ES3) has an expense ratio of 0.3% per annum.

ETFs generally charge a lower fee than unit trusts, making ETFs an attractive form of investment. The low fee makes a lot of difference over the long-term. Warren Buffett also recommends investing in low-cost index funds instead of putting our money into hedge funds for cost reasons, as reported by CNBC.

D. Liquidity and spread

ETFs have market makers to provide continuous bid and ask quotes to ensure the availability of prices and liquidity. However, there can be times when the market makers are unable to provide a continuous quote for the ETF. As a result, buyers or sellers may not be able to buy or sell an ETF promptly at a reasonable price.

We should always ensure there are sufficient liquidity and tight bid-ask spreads when investing in ETFs. The simplest ETFs are those that offer a direct replication of the underlying index by investing in the index’s constituents. The method of replication can be found in an ETF’s prospectus.

E. Simplicity is best

There are some ETFs that offer leverage by using derivative instruments to amplify the returns of an underlying index. ETFs that promise three times the return of the index it tracks may sound attractive, but such ETF can also lead to three times the loss when the index turns south. Unless you konw what you are doing, ETFs are risky and are not suitable as long-term investments.

Sticking with simple, passive ETFs may be a better way to preserve wealth over the longer term.

The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. 

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