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What to look for when choosing ETFs
SaxoInvestor
Saxo Group
ETFs are a great way to start investing and are a popular choice for both beginners and experienced investors due to their trading flexibility, potential for diversification and tax efficiency. ETFs have gained popularity among investors over the past few decades. As a result, an increasing number of asset managers are offering these products, significantly boosting their availability.
The vast array of ETFs offered is beneficial but this can also make choosing the right one challenging. A helpful way to determine what kind of ETF you want to choose is by looking at the fund's KID (Key Information Document). The KID holds essential information about the fund's investment objective, cost and charges, historical performances, whether it is accumulating or distributing and other key characteristics.
Before making your investment, you should consider the following factors:
- Investment objectives and strategy: What are the fund’s investment goals, what type of securities can the fund invest in and what strategies can be employed. Do the fund’s objectives match your own investment objectives and financial goals. For example, if you want to invest in technology stocks, opting for a Nasdaq ETF would be more suitable than an S&P 500 ETF.
- Underlying index or asset class: Most ETFs track an index, so it's crucial to understand the type of index they follow. Is it a broad market index or a sector-specific one? While sector-specific indices offer targeted exposure to particular industries, they may sacrifice diversification.
- Tracking error: ETFs are designed to replicate the performance of a specific indices. However, an ETF's performance can sometimes diverge from the index they track, a phenomenon known as tracking error. A lower tracking error is preferable, as it indicates that the ETF is effectively tracking the index without taking on additional active risk.
- Liquidity: The more liquid an ETF is, the tighter the bid-ask spread tends to be, which translates to better prices and lower costs for investors. When choosing between two ETFs, it's generally advisable to select the one with higher trading volume and assets under management (AUM) as it often indicates greater liquidity.
- Tax efficiency: Due to their structure, ETFs are generally more tax efficient than mutual funds because they generate fewer capital gains, resulting in lower tax liabilities for investors. However, not all ETFs have the same tax treatment, so understanding the tax implications of your investment is essential.
- Performance: Though past performance is no guarantee of future results, it is important to review a fund’s historical performances to gauge its potential. Examining an ETF's past performances will also allow you to compare the fund’s performance to its benchmark and assess whether the tracking error falls within reasonable bounds.
- Cost: Although ETF fees are generally lower than those of mutual funds, it's still important to review the costs, as not all ETFs charge the same fees. Some funds, particularly actively managed ETFs and thematic ETFs, may have fees that are more comparable to mutual fund fees. Fees matter because they eat away at a fund’s performance and the higher the fees, the greater the impact on the fund’s performance over time.
You've reached the end of our ETF series. We hope you now feel confident about investing in ETFs and are equipped to make informed decisions.
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