Today, investing in ETFs is the most attractive solution for many investors, both beginners and with extensive experience.
At the same time, many investors do not fully understand the essence of this investment instrument, which means that they choose it not consciously and to a greater extent intuitively.
In this article, we will look at what you need to know about ETFs in order to choose the right and necessary fund. To do this, we will take a closer look at several key points that determine the choice of an ETF:
- The parameters of the ETF that affect the choice of the fund.
- The technology of choosing an ETF.
- The practice of selecting ETFs.
Parameters that affect the choice of an ETF
At the moment, there are a huge number of different ETFs that differ in many key parameters and can bring completely different investment results.
In general, it is worth noting that the basic principle of investing in ETFs is exactly the same as in other financial instruments, for example, such as stocks.
The first is that the selected ETF must meet the global investment goals of a particular investor, such as investment horizons, the size of the potential risk of the ETF, the expected profitability, the availability of cash flow, and so on.
The second is that despite the fact that the ETF itself is a ready-made set of various assets, the principle of investment diversification is still relevant when investing in an ETF. It is never worth buying any particular investment instrument and investing only in it, it is always better to make a diversified investment portfolio and evaluate its stability characteristics.
In order to understand how a particular fund corresponds to the personal investment preferences of each investor, you need to understand what criteria characterize the investment profile of an ETF.
Asset type
ETFs can consist of different types of assets, which fundamentally determines what investment result the fund will bring in the future. There are ETFs that consist of stocks that duplicate certain indices of stocks of industries, countries, and sectors of the economy. There are ETFs that consist of conservative financial instruments, such as money market instruments and bonds. There are ETFs that are based on a commodity group, precious metals, for example, gold. And there are also mixed funds that invest in different types of assets.
In general, it is worth understanding that the ETF carries the same risks as the instruments included in it, this will determine the main risk/return profile of the fund. ETFs consisting of stocks and commodities are high-risk funds, the quotes of which can grow strongly and fall strongly, and can thoroughly rattle the nerves of an investor. Along with this, there are ETFs consisting of bonds and money market instruments. The quotes of these funds have a smaller amplitude of fluctuations and are prone to more measured and stable growth, but they also potentially have a lower yield.
Read more: How to invest in stocks and what you need to know
It is also worth noting an important point that investing in bond ETFs is not a full-fledged substitute for investing in bonds themselves. The thing is that a bond is a fixed-yield instrument. It has a specific maturity date, and bonds are extinguished at a known price, that is, at par, this provides investors with a pre-known level of profitability. An ETF that consists of bonds does not have a specific maturity date, the fund's yield is always formed due to coupon payments on bonds and the current market value of the bonds themselves, there is no fixed maturity date and a specific price. Therefore, bond ETFs are not risk-free instruments and cannot bring a fixed, pre-known yield. They are characterized by the fact that they have a smaller amplitude of fluctuations than commodity ETFs and equity ETFs. Also, their quotes may decline during the manifestation of crisis moments, just the decline of such ETFs, as a rule, passes at a slower pace.
The currency of the ETF
On Exchanges, as well as on various other platforms, ETFs are traded in different currencies. Moreover, from the point of view of an ETF, there are two concepts of an ETF currency, this is the asset currency and the settlement currency. For example, an ETF may contain foreign currency assets, but it is listed on the stock exchange, for example, for rubles. Or, for example, to have foreign currency assets as part of it and be quoted for the currency as well. All this gives investors considerable flexibility in the currency diversification of the portfolio.
Industries, economic sectors, geographical features
As a rule, an ETF consists of a set of assets that have some common characteristic. Often these are industry, geographical characteristics and belonging to various sectors of the economy. For example, ETFs can combine shares of a particular industry or sector of the economy. Also, many ETFs combine securities on a geographical or country basis. As a rule, such ETFs duplicate the main national stock indices.
If an investor understands any specific advantages and attractiveness of a particular sector of the economy, industry or region, then with the help of an ETF, he can make an additional investment emphasis on this.
Read more: What is a Bond: types, risks, difference from stock, pros and cons
Dividends in ETFs
As with stocks, there are dividends on ETFs that consist of shares. But unlike stocks, a fund with dividends can act in different ways. Dividends can be paid to investors, or they can remain inside the fund and be reinvested again. In this case, for the investor, this gives an understanding of the characteristics of whether this ETF will generate cash flow in the form of dividends or not. Investors whose investment goals require generating regular cash flow from investments should choose funds that pay out, rather than reinvest, dividends.
Replication of ETFs
Here, investors can expect certain surprises. Replication gives the investor an idea of how the ETF really works inside, and this directly affects the risks and costs. ETFs are physical replication, when the fund physically buys securities from the market and forms an investment portfolio according to the necessary structure, synthetic replication, when assets are not physically bought, and all the characteristics of a physical asset are completely simulated at the expense of derivative financial instruments, and double replication, this is in a sense a trick when the fund operator does not bother to form a physical portfolio of securities, but simply buys another ETF similar in composition. This can be called a kind of resale of ETFs.
For an investor, it is worth understanding that a synthetic replication fund will always be more risky than a physical replication fund, since in this case the fund bears additional risks of counterparties in a transaction with derivative financial instruments. It is also worth noting that double replication funds will always bring lower returns than simple physical replication ETFs, since they include a double commission to the operator of the fund selling the ETF and to the operator who formed the physical fund.
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ETF Operators
An ETF operator is an investment company that has directly formed and released an ETF to the market. Moreover, there are quite a lot of ETF operators. Often, the investor faces a choice not only in terms of choosing the fund itself. But also a specific operator. So an ETF, for example, for shares of companies included in the US S&P500 index, can be issued by different operators.
For an investor, the choice of an ETF operator lies in the coordinates of the commission that the operator takes for managing the fund and the reliability of the operator.
Thus, the variety of characteristics of an ETF makes the choice of a fund not so simple and unambiguous. To do this, the investor should first understand the specific ETF and understand how it corresponds to his investment goals.
Technology of choosing an ETF
As with the choice of any security, when choosing an ETF, an investor has two standard ways to solve this problem:
- Step-by-step study of each fund separately, accumulation of all information and formation of a general picture of the entire fund market. The investor can get information about each fund on the official website of the fund operator or on the exchange where they are traded. This is a very long and time-consuming process, during which the investor must independently find out all the key parameters and characteristics of a particular ETF and make a comparison with similar funds. Of course, this is a very difficult and time-consuming task for a private investor, but in return, the investor gets a wealth of experience and hones the skills of conducting analytics.
- Using a professional screener that allows you to instantly scan the entire ETF market. The stock exchange screener is a service aimed at making the investment process as easy as possible, especially when investors are faced with a very large number of securities for which there are many different parameters. Various stock and bond screeners have already gained wide popularity, but there are practically no professional ETF screeners in the Russian-speaking part of the Internet. However, as we can see, ETFs are not such simple tools as it seems at first glance. For their qualitative selection, it is necessary to analyze many parameters, which is a very time-consuming process.
The ETF screener allows you to analyze all the key parameters of the ETF in a few mouse clicks due to the built-in filters.
The country and industry affiliation of the ETF, the type of fund assets, the dividends on the ETF, the settlement currency and the currency of the ETF assets, the replication of funds and the choice of the fund operator. Moreover, this is not a complete list of available screener filters. The full scope of the screener filters allows you to make the most accurate and up-to-date fund selection for a number of additional statistical and fundamental parameters of the ETF.
The practice of choosing an ETF
From the point of view of the behavior of quotations, an ETF is not much different from a regular stock. Depending on the selected fund, ETF quotes are also subject to strong growth and decline cycles. Therefore, the same requirements apply to the process of investing in ETFs as to shares.
One of the main elements of investing in ETFs is diversification. At the same time, it should be carried out both in terms of choosing the type of fund itself, and in terms of the currency component. Due to the fact that there are ETFs on the market that include assets in different currencies, as well as due to the fact that ETFs are also calculated in different currencies, it will not be difficult for an investor to form an ETF portfolio according to a certain currency strategy.
In order to completely "get away" from exchange rate differences, it is always most relevant to apply a strategy of neutral currency diversification, when the foreign currency and ruble shares in the portfolio are fully balanced and make up 50% of the portfolio.
To form a portfolio from an ETF, we adhere to the following criteria:
- The share of assets with a lower amplitude of fluctuations in quotations, that is, these are bond ETFs and money market ETFs, should make up the majority of the portfolio, and occupy a share of about 70-80% of the portfolio. The remaining share of the portfolio can be distributed among more volatile and risky assets, such as commodity ETFs and equity ETFs. At the same time, we choose funds only for physical replication of the largest ETF operators.
- Currency-neutral diversification from funds. The share of currency and ruble ETFs is equal to 50% each.
- ETFs are only physically replicated by the largest and most well-known operators.
Conclusion
With a balanced professional approach, investing in ETFs can demonstrate good performance. However, in order to implement this approach, an investor needs special knowledge of the theory of portfolio investment and support for special services for choosing ETFs, which allow assessing the risks and potential profitability of each instrument, as well as forming a portfolio and evaluating its stability and effectiveness.