How to choose the best ETFs for your investment goals

Consider your investment needs, duration, diversification goals and risk appetite

Investors should consider why they want to enter the ETF space. Getty Images

There are more than 13,000 global exchange-traded funds available for investors.

Shortlisting it by ETFs with assets under management greater than $10 million, the active number comes down to nearly 10,000.

While $10 million is a bare minimum amount considered for investment, other major investors would want to seek a higher liquidity AUM for participation.

Nevertheless, the total AUM managed by these ETFs is around a whopping $10.5 trillion, according to the latest figures.

To understand its significance, the net AUM growth has seen remarkable growth, especially over the past six years.

During 2016-2017, the net AUM base was in the range of $3.5 trillion. The period post-2017 has seen a threefold growth in the net asset base of these ETFs.

Amid such a diverse product base, choosing a suitable ETF has become a bit of a complex puzzle to decode but there are a few simple and essential questions that you can ask to determine what is best for you.

Investment needs

The foremost point investors need to consider is establishing why they need to enter the ETF space.

For instance, a new entrant to the market would like to invest and enter via a US large-cap passive ETF that tracks and invests in big US blue-chip companies.

On the other hand, existing investors with sizeable long-term holdings in prominent blue-chip names would want to invest in actively managed ETFs that continuously change their allocations over a period of time.

Type and duration of ETFs

Once an investor has decided to allocate a certain amount for an ETF, the next crucial step to consider is determining which ETF to invest in and the duration.

While certain passively managed funds such as SPY (SPDR S&P 500 ETF) typically require investors to be patient and hold for the long term, actively managed ETFs such as the JP Morgan Equity Premium Income ETF usually require investors to look for returns and go for entry/exits actively. This is due to the active and high beta nature of such ETFs.

Diversification to other ETF baskets

Investors may also consider diversifying beyond the existing ETF to fulfil other investment objectives.

For instance, an existing long-only US portfolio holding may want to use an ETF that buys out of the money puts or a collar strategy on the same basket of instruments (ETFs like HEQT and XTR).

Similarly, an investor with an active equity-only portfolio may want to diversify to fixed income using ETFs like TLT and SHV, among others.

Risk tolerance

The returns generated on any investment product are often a function of an investor’s risk-taking capability.

The very reason for the existence of innovative, synthetic products linked to derivatives is to provide investors with added returns to their existing passive portfolio holdings.

Investors unwilling to take a risk can, instead, focus on passive ETFs and even traditional bond and bank money market products.

Below are the key points to consider when evaluating a risk tolerance approach.

Performance measures of an ETF

This primarily refers to how closely the ETF tracks and matches its underlying domain and product holdings.

It involves knowing the ETF’s tracking error and tracking difference for establishing its actual performance.

Investment style and structure

A passively managed ETF invests and tracks the performance of a well-established benchmark index belonging to a particular category, sector or country.

On the other hand, an actively managed ETF uses its in-house strategies and products to achieve its desired and stated investment objectives.

Picking the ETF index

Broadly filtered, ETFs can be categorised into the following:

Region: global, domestic, country-specific, demographic-specific.

Asset class: equities, fixed income, hybrid, alternate like real estate, commodity, or synthetic derivative trackers.

Sector: individual equity sectors like tech, energy, consumer staples; or market cap status like mega cap, large cap, mid cap, small cap.

Identifying a suitable trade-off

An ETF with a standard objective to provide constant dividend/income returns would likely have holdings in established divided aristocrats and investment-grade bonds. Such ETFs would typically be off low beta and low alpha profiles.

On the other hand, an aggressive and high alpha/high beta would typically invest in high-growth and beaten-down names.

The investor needs to make a suitable trade-off and imagine the worst-case scenario before investing.

Knowing when to enter and the costs involved

Entering a growth ETF when the market seems wobbly would be considered a lousy investment approach.

On the other hand, starting a systematic investment plan during a market downturn or when the market is already consolidating in a bear market would mean the investor achieving good returns in the longer term.

The investor also needs to bear in mind the costs involved, which include the fund’s expense ratio and the transaction charges for entering and exiting.

Not taking any risk is itself a significant risk. Waiting too long for a particular ETF level or overestimating the depth of a current market sell-off or the ongoing market bull run can prove costly.

There is no better time than today to start planning and allocating funds towards investment goals.

Vijay Valecha is chief investment officer at Century Financial