Boasting attributes like efficiency, low costs, transparency and ease in tradability, exchange traded funds have attracted a wide following in both institutional and retail investors for gaining exposure to the various market segments. However, with over 1,300 ETF products available, investors will need to sift through and consider factors that are most in line to their investment goals.
In a recent Financial Times article, David Gardner, head of sales for iShares EMEA, pointed out five things investors should consider when picking an ETF: product structure, tax, performance, trading valuations and costs. [What are ETFs?]
- Structure. In their most basic form, ETFs are either considered “physical” or “synthetic.” Physical ETFs are backed by component shares from a benchmark index. In comparison, synthetic ETFs try to achieve their intended investment target by holding derivatives underwritten by a counterparty, or investment bank. [Know What Your Fund Holds]
- Additionally, exchange traded notes, or ETNs, are senior, unsecured debt obligations issued by financial institutions. [What Are ETNs?]
- Taxes. Investors need to be aware of what the ETF’s product structure is how it may play out come tax season. For instance, most passive or physically backed ETFs will be taxed at the regular capital gains rates, but funds that hold derivatives will require a K-1 form. Additionally, some commodities, namely precious metals, may be taxed as a collectible. Investors should consult their tax experts for detailed information. [Tax-Loss Harvesting]
- Performance. An ETF’s performance may be measured by how closely the fund mimics its underlying benchmark by comparing the underlying net asset value (NAV) to a fund’s price, or more simply known as tracking error.
- Trading Valuations. Like stocks, ETPs may be traded throughout the day on an exchange, although ETFs provide exposure to a basket of securities as a single investment tool. Investors will need to monitor ETPs like any other stock.
- Cost. ETFs are very low cost investment vehicles. Investors should take note of the funds’ expense ratios, which cover management, administration, custody and auditing fees. Additionally, investors should consider the total cost of ownership, which includes brokerage fees, rebalancing costs and trading spreads.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.