How to choose the best ETFs

We're big fans of exchange-traded funds (ETFs). ETFs, which are listed on the stock market, are generally passive' funds they aim to track the performance of a particular index or commodity, rather than trying to beat the market, as an active' fund does.

So, if the FTSE 100 rises by 10%, you'd expect a FTSE 100 ETF to rise in value by roughly 10% too. The big advantage of ETFs is that they offer exposure to a wide range of markets without having to shell out a hefty fee to an active manager, who will more than likely fail to beat the market consistently.

But as with any financial product, some ETFs are better than others, and their growing popularity means there are ever more to choose from. And there are also their unlisted counterparts, index tracker funds, to consider. So what should you look out for before buying?

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1. Check the tracking

The whole point of an ETF is that it tracks an index. So the first thing to do is to compare its returns against the returns of the index it's supposed to track. An ETF incurs some running costs, so the tracking will never be 100% accurate this is known as tracking error' but the closer the match, the better.

It's also worth considering the method the ETF uses to track the index. Buying all the shares in an index full replication' is the best approach, if it can be done cost-effectively.

Partial replication', or optimisation' where the manager buys a representative group of the shares in the index is another method, but may lead to greater tracking error.

The third method is where the ETF provider enters in to a deal (known as a swap) with another party (a counterparty). The counterparty agrees to provide the return of the index in question, while the ETF provider owns collateral to protect investors against the counterparty going bust. This is known as a synthetic' ETF and exposes the investor to two main risks.

Firstly, the counterparty may be unable to match the return of the index. Secondly, the counterparty could go bust in a financial crisis. If that happened, the ETF provider still has the collateral, so investors wouldn't lose all their money. But it would be a painful process and your eventual return would probably be nowhere near that of the index.

2. Check the price

The total expense ratio (TER, also known as the ongoing charge) is a measure of annual costs. It can be found in the key investor information document (KIID) on the website of the ETF provider or your broker.

The TER includes such things as the annual management fee and other administration costs, but usually doesnot include trading costs and taxes.The cheapest ETFs have TERs ofaround 0.15% a year.

However, ETFs have other costs attached. Because they trade on the stock exchange, you have to pay dealing commissions to your broker to buy and sell them. This can be anything from £5-£12.50 a trade, which can represent a hefty one-off cost if you are investing relatively small amounts.

On top of that is the difference between the buy (offer') price and sell (bid') price of the ETF the bid-offer spread'. Spreads are normally quite small on the larger funds, but it's a different story for smaller funds, or those that own shares that are harder to trade, such as emerging-market companies.

It can help to avoid trading near the start or the end of the trading day, when there are fewer buyers and sellers around. If the spread is too big, then don't trade. Wait for another day.

3. Don't pay a premium

Index tracker funds are another type of passive fund. They also track an underlying index, but are not listed on the stockmarket. This means your money is invested at the net asset value (NAV) per share (although some funds do charge for the diluting costs imposed on existing unit holders, so check this before you buy).

In other words, the price is driven entirely by the value of the underlying portfolio. But with an ETF, the share price is determined by supply and demand for its shares.

So, the ETF share price may sometimes rise above the NAV (it trades at a premium), or fall below it (trading at a discount).

In theory, this isn't meant to happen the price of an ETF is regulated by active participants' who can create new shares or redeem existing ones to bring demand and supply in to balance and help close any premiums and discounts. But it does occur.

For example, the ETF may hold foreign shares, which have different trading hours, or it may hold bonds that don't trade very often. This sometimes means the ETF's share price cannot adjust to its NAV quickly. You also tend to get gaps opening when markets are volatile. Try to avoid buying at a premium.

So why not go for a tracker fund instead? Because generally ETFs are cheaper in the long run. While you have to pay trading commissions, they don't attract platform charges (a fee your broker charges you for owning them).

This means an ETF often ends up being better value than an index fund with the same underlying return as I demonstrate in the box on the left.

ETFs vs index funds

The Vanguard Japan Index fund has a total expense ratio (TER) of 0.3%, and a platform fee (what your broker will typically charge) of 0.25% a year, giving an annual cost of 0.55%.

Vanguard Japan ETF (LSE: VDJP) has a TER of 0.19% and a typical bid-offer spread of 0.21%. You'd also pay commission to your broker to buy it. That gives the ETF a cost of 0.4% (plus the commission fee) in year one, and 0.19% thereafter.

If you invest £1,000 in each, assuming an annual return of 6% and a £5 commission on the ETF, the difference between the value of the two funds is not great. After four years the ETF pulls ahead. The higher the commission fee, the longer it takes for the ETF to overtake but the bigger the initial investment, the quicker the ETF wins out.