5 checks before buying ETFs

ETFs are so popular right now that there seems to be an ETF for almost everything. Of course there are the usual ETFs that follow the regular indexes. For example: the Dow 30 and S&P 500. But some providers offer ETFs on more specific topics like games, space and millenial themes. There are ETFs in all shapes and sizes. Still, it is not wise to just include all kinds of obscure ETFs in your portfolio. Selecting the right ETFs is easier than selecting stocks, but there are a number of checks to consider.

1. Check the costs

As an investor you want to keep costs low. Of all the checks this might be to most important one for ETFs. Costs can significantly reduce the return on investment. With ETFs you pay the provider for managing the fund. Fortunately, most ETFs are passively managed funds, which means provicers can keep costs low.

Costs are expressed in the ‘Total Expense Ratio’ or TER for short. It is a percentage over the price of the relevant ETF. These costs are settled daily over the price without bothering investors with it.

There are a number of things that can affect the expense ratio of an ETF, among which:

  • How activily the ETF is managed
  • How much is spent on marketing
  • How much demand there is

In short: ETFs from common indices such as the Dow 30 or S&P 500 have low costs. The more the ETF focuses on an obscure corner of the market, the higher the costs will typically be.

2. Physical or synthetic replication?

ETFs can track an index using two methods: with physical or synthetic replication.

With physical replication the ETF actually holds the shares of the index in its portfolio.

The shares are bought in the same ratio as the index, which allows the ETF to track the performance of the index. The provider buys the shares from all invested capital of its investors.

With synthetic replication the index is tracked using a ‘swap agreement’ with a third party.

How a swap agreement was made is often very vague. The big difference is that the shares of an index do not have to be physically held. This makes a considerable difference in costs for the ETF provider. As a result, synthetic ETFs generally have lower costs than physical ETFs.

Before you stockpile synthetic ETFs in your portfolio, consider that the risks are higher than with the physical variant. The shares are not owned by the provider. As an investor, you are therefore dependent on the swap agreement between the third party.

Only invest in the physical variant. The costs may be a bit higher, but the added risk is not worth holding synthetic ETFs.

3. Check the country of origin

ETFs issue dividends, just like stocks. If the country of origin is not your own, taxes may be deducted before pay-out. If you also need to pay taxes on dividends in your own country, you lose some potential return. This can be circumvented by only buying ETFs from your own country (if possible).

You can check the country of origin using the ISIN code:

The ISIN code can tell you the country of origin of the ETF.

4. Are dividends payed or reinvested?

ETF managers can choose how to distribute dividends to investors: either by cash paid or by reinvesting it in the ETFs underlying assets. If you buy ETFs that pay dividends, you will receive this as cash deposited into your account. Reinvesting or accumulating ETFs do not pay dividends but reinvest them automatically. This increase in assets is reflected in the price of the ETF.

One benefit of accumulating ETFs is the fact that you don’t need to reinvest the cash yourself. It saves you some time and transaction costs. If you want to live off dividends, than an accumulating ETF is not the right fit for you. In that case people with a lot of capital are better off buying ETFs that distribute the dividends.

The choice between a distributing and accumulating ETF is entirely personal. Choose the ETF that fits your needs.

5. Check sector and region allocation

ETFs that track an index such as the Dow 30 are quite straightforward. These have the same stocks as the index and also in the same ratio. As a result, you will always get a return that is approximately equal to the index.

However, similar ETFs that track less common indices can have significant differences between providers. The exposure to certain regions and sectors can differ per ETF. For example, see below for a comparison between two emerging market ETFs.

Two ETFs for emerging markets, but with different region allocations

On the left you see an ETF from iShares and on the right from Vanguard. The iShares ETF consists of 39% Chinese stocks, while Vanguard has a 44% allocation to the same region. In addition, iShares invests 13% of its capital in South Korean stocks, while that country is not even in the top 4 at Vanguard.

Similar ETFs can also differ widely when it comes to the distribution across sectors. Where one provider invests in more financially oriented shares, the other can hold on to more technology shares.

If you want to invest in a particular themed ETF, always check if there are multiple providers for it. Then compare the ETFs on the first 4 checks above. If the differences are small you can compare the sector and country distribution. Then choose the ETF that best suits your portfolio.

Bonus: Check the prospectus and other info about ETFs

If you need more information about an ETF, you can always find extensive prospectuses and data sheets. ETF providers usually have dedicated pages on their websites. So if you still have doubts after checking the above 5 points, you can check these pages for more information about ETFs.

Buying an ETF isn’t rocket science. Nevertheless, the 5 checks above can help to select the right ETFs. Nowadays there are many on offer, so it might help to separate the stinkers from the winners.