What do you need to consider before you buy an ETF?
Before you buy an Exchange Traded Fund (ETF) there are a number of criteria you should first take into consideration such as the following:
- Investment Policy Statement (IPS): Have a clear knowledge and understanding of your IPS and the job vacancy that you are trying to fill by investing in Exchange Traded Funds (ETFs). This understanding will help you to navigate your ETF options and narrow your analysis to a select few. By adhering to your IPS guidelines, you will maintain an acceptable investment risk level and maintain a higher degree in investing success.
- Compare the design and construction of each ETF: By examining the ETFs design and construction you will gain a greater understanding of how the ETF should behave under certain economic and stock market conditions. Understanding the ETF structure will help you to ensure that you are hiring the right ETF for your investment job vacancy. Comparing ETF structures will help you to select the right candidate for the job.
- Examine the ETF’s Tracking Error: How closely does the ETF’s performance (good and bad) match that of the underlying index or benchmark? How was the Tracking Error during volatile stock markets? As each ETF comes with its own Tracking Error, you will want to ensure that the ETF consistently delivers close to the promised constituent performance.
- Compare the annual management expense ratios (MERs): Compare the annual management expense ratios (MERs). If you are comparing two or three ETFs and they are similar in their structure, tracking error, then why not select an ETF with the lowest annual costs. Be sure to read all fine print and footnotes. As the saying goes, “The Devil is in the details.” Make sure when comparing ETF costs that you are comparing apples to apples.
- Compare the ETF’s calculated net asset value (NAV) with its stock market or trading price: Is the unit trading at a premium (above) or discount (below) its calculated NAV? If it’s trading above its NAV, you might be paying too much for the ETF. Is one of the ETF candidates trading at a price that is at or under its NAV?
- Consider delaying your purchase and sell orders until after the markets open for trading: There is reason to believe that ETF prices can be distorted when the stock markets open as the ETF is attempting to guess the opening share, commodity and currency prices. The ETFs often use the previous day’s closing prices and early pre-market Futures contract prices to estimate opening levels for the underlying benchmarks and, thus, opening ETF prices. There are also some that suggest waiting until later in the trading session when transacting ETFs that are U.S. Dollar influenced (i.e. commodities, precious metals, etc.). Experts suggest that the market liquidity for these types of ETFs is better late in trading sessions.
- Liquidity is important: If you have a choice between similar ETFs, select the ETF with the larger trading volume. Even though the Creation and Redemption ETF process is able to provide unlimited liquidity, frequently traded ETFs already have a demonstrated and consistent liquidity. Newer or more specialized ETFs may trade infrequently and as a result they may experience wider pricing fluctuations and wider Bid and Ask spreads. (The Bid is what an investor is willing to pay to buy, and the Ask is the price an investor is willing to sell.)
- If possible, avoid buying and selling on days when stock prices are volatile: Again there is some evidence that ETF market prices have an increased tracking error, when compared to the ETF’s NAV, on days when stock prices are volatile.