Investing For The Long-term (Retirement)
How to Invest in ETFs, Our Chosen Vehicle
Step 2/3: Picking the ETF
8 min read.
To pick an ETF to buy, there are 6 criteria to consider:
- The total cost of holding the ETF, measured by the Total Expense Ratio (TER).
- The replication method and tracking error.
- The dividend distribution policy.
- Liquidity, meaning how easy it is to trade large sums of the ETF.
- Exchange market where it is traded and broker commissions.
- Whether it is currency-hedged or not, and whether you want it to be (see discussion above).
You can find the comparison I made of ETFs that tracked the MSCI World index here: etf-analysis.xlsx. You may want to follow the brief explanations of each criterion above by analyzing how different ETFs compare in each criterion. Once again, the provided list is not extensive, even when just considering the MSCI World. Do your own research.
Total Expense Ratio (TER)
By now, you may understand that an ETF is a service like any other. Financial institutions build algorithms that automatically trade stocks in an attempt to build a portfolio that performs on track with a specified index. And then they sell this service to investors.
Although with passively-managed funds there is no team of financial experts doing the trading decisions – these decisions are made by the algorithm – there are still costs to maintaining and offering then. Namely, the cost incurred when executing the trades required to building the ETF portfolio, the cost of marketing the ETF to investors, infrastructure costs, etc. And then, like any other business, financial institutions need to make profits by selling this service. So it’s only natural that ETF providers charge their investors. And they do so with an Annual Management Fee.
This Annual Management Fee consists of a percentage applied to the total value an investor has on the ETF at the moment it is charged. This percentage is called the Total Expense Ratio (TER). Naturally, you want it to be as low as possible.
Replication Method and Tracking Error
You may think that ETFs, to track the underlying index as closely as possible, hold an exact replication of the index in their portfolio. This method of replication is called “Physical Replication”. However, attempting to build an exact replica of an index of over 1500 stocks would lead to a high volume of trades with the implied trading costs. So, many ETFs apply alternative methods to replicate the index with lower costs.
The simpler is to do a “Physical Replication” but only of a subset of the index, ignoring the stocks that have a very small weight on the index. This is called “Physical Replication with Sampling”. Another method called “Optimized Replication” also consists of only considering a subset of the index, but uses a more complex mathematical model to choose which stocks to ignore. And then there are other more complex methods, such as “Synthetic Replication”, which do not actually hold the assets but hold other financial instruments – like swaps. But, to be honest, I didn’t dive too much into this.
Ultimately, what we’re concerned about is the ETFs’ tracking accuracy. We want the ETF to track its underlying index as closely as possible. And you assess an ETF’s tracking accuracy by measuring the “Tracking Error” (see definition here). The tracking error is simply the difference between the underlying index’ performance and that of the ETF. The lower the tracking error, the better.
You can analyze tracking errors on two websites: justetf.com (example for MSCI World here) and trackingdifferences.com.
Don’t overlook the tracking error. Even a slightly higher error, if consistent over several years, can make a huge difference in accumulated returns.
Dividend Distribution Policy
When you own stock, you own part of the company. Therefore, you’re entitled to the equivalent part of the company’s profits. Of course, CEOs may decide to not distribute profits to shareholders, but at least the bigger, more mature companies tend to distribute dividends since their profits are more stable.
Although it’s impossible to predict how much dividends you’ll earn with your investments, it seems to be a general guide on the internet to assume you’ll receive 2% of your total investment in dividends. So, for example, if you have 10.000€ invested in the stock market, as a general guideline you can expect to earn 200€ in dividends that year.
Every ETF has a defined policy on dividends (often called “Use of Profits”): either the ETF distributes the dividends to the investors holding the ETF so that they can add them to their annual income – a “Distribution” policy – or it automatically reinvests them – an “Accumulation” policy.
Although it may seem attractive to earn a few hundred euros per year through dividends, there are two (possible) reasons to opt for an “Accumulation” ETF:
- Distributed dividends are taxed by 28% and some brokers charge a commission on earned dividends (from the brokers I considered, up to 2% with 5€ minimums).
- If you intend to reinvest your earned dividends manually, you may not be able to use them all to buy more ETFs, because the amount is not divisible by the ETF’s price.
On the first point, to be honest, I’m still unsure whether the automatically reinvested dividends are subject to taxes or not. From the international blogs I read, it seems that taxes are due. But in a Portuguese forum (see here), it seems that in Portugal you aren’t taxed for the automatically reinvested dividends. I need to ask this to my investment bank.
On the second point, let’s take the example above of earning 200€ in dividends in a given year. Your ETF distributes the dividend, which entails a 28% + 5€ deduction. You earn a net 139€ dividend. If the ETF’s price is 55€, you’re only able to buy 2 units of that ETF, leaving 29€ out. If you had opted for the automatic reinvestment, you could have invested the whole 200€ (assuming you’re not taxed), even though it’s not divisible by 55€. You would have bought 3 full units of the ETF and part of a fourth. Note that this calculation is managed by your ETF provider.
Read more about this here.
Since my goal is to maximize my future investment returns, I’ve opted by an “Accumulation” ETF.
Liquidity
Liquidity stands for how easy and cheap it is to trade large volumes of an asset. Assets are not like a savings account, from where you can withdraw whenever you want with zero penalties. With assets, you have to sell them, which means that there has to be someone willing to buy your assets from you.
The stock market is an auction. For every asset, there’s a bidding price, which is the highest an investor is willing to pay for it, and an asking price, the lowest an investor is willing to sell it. The difference between the two is called the bid-ask spread. The lower the spread, the easier and cheaper it is to trade the asset (both to buy and sell), and the more liquid the asset is considered.
Imagine yourself 30 years from now, old and boring, and trying to withdraw your investment. Most likely you won’t withdraw it all at once the moment you retire. You’ll instead calculate an amount that is safe to withdraw every year (see the Safe Withdrawal Rate as an example method you could use to calculate this amount) guaranteeing that you don’t deplete your portfolio before you die. Still, you want to be able to withdraw that amount without losing much of its value in the bid-ask spread.
The difficulty here is that liquidity is very difficult to measure. There is no one way to assess a fund’s liquidity, but you can have an impression by:
- Analyzing how much of the asset is traded on a single day.
- Analyzing the bid-ask spread.
- Assessing how well-known the institution providing the ETF is and the investors’ opinions on the ETF. Reddit’s FIRE communities (Financial Independence and Early Retirement) can help you with this. Examples: r/Fire and r/EuropeFIRE.
Exchange Market Where It Is Traded and Broker Commissions
The only reason why the exchange market in which the ETF is listed is relevant when choosing the ETF is that the commissions charged by brokers when you buy or sell the ETF differ according to the ETF’s listing.
A single ETF, especially the most sought for by investors, will most likely be listed on more than one stock exchange. The ETF I invested in is listed in Mexico, Italy, Frankfurt, Amsterdam, London, and Switzerland. Because the trading commissions my broker charges are lower in Euronext exchanges, I buy the ETF in Amsterdam (a Euronext stock exchange).
Note that some brokers offer some specified ETFs free from the trading commission. But we’ll discuss this further in the next chapter – Picking the Broker.
Currency-Hedge
The issue concerning currency-hedged has been detailed earlier, so I’m not going to repeat it here. The bottom line is, we shouldn’t pick EUR-Hedged ETFs because we’re investing in the long-term.
iShares Core MSCI World UCITS: The ETF I Chose
I ended up picking iShares Core MSCI World UCITS. Its “Use of Profits” policy is accumulative and is traded in Euronext Amsterdam, where I pay lower commissions with my broker.
It does have a TER of 0,20%, which is relatively high compared to its competition that goes as low as 0,12%. But for a difference in 0,08% a year, it has a very low tracking error and seems to be the most liquid of MSCI World ETFs, as can be seen here. It’s also the oldest MSCI World ETF I found, which gives me more confidence in the tracking error. It’s cheaper competitor was launched just February 2019, so there’s not enough data to properly assess its tracking error.