Individual Investors

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How to Pick the Right ETF? Part 1

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Part 1 | Investment Strategy

Investors buy ETFs because they like their investment strategies. They give them access to things they want to own and help them achieve their financial goals, but there are stark differences between ETFs’ investment strategies. Below is a guide.

What assets does the ETF buy?

ETFs can own many different assets: global shares, Australian shares, bonds, precious metals—and more. Some ETFs can even own multiple types of assets—what are called “multi-asset ETFs”. Knowing what assets an ETF holds is therefore crucial, as it can help determine whether the fund is suited to your goals and risk tolerance.

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Source: Moneysmart, ETF Securities, 25 May 2021

As a general rule, ETFs that buy shares are riskier but have historically produced better returns. ETFs that buy bonds, cash and gold are less risky but have produced lower returns.

What segment or sector is the fund concentrated in?

Within asset classes, ETFs have different concentrations. Some funds do this incidentally, others do this deliberately. Plain vanilla ETFs, which track famous national share market gauges, often have concentrations incidentally. For example, ASX 200 ETFs are concentrated in the financials and materials sectors, due to Australia’s large banks and miners.

Other funds deliberately focus on sectors and segments, believing they offer opportunity. For example, our own ETFS ROBO Global Robotics and Automation ETF (ASX Code: ROBO) purposefully concentrates on the technology and industrials sectors of the economy.

Knowing what sector or segment a fund is exposed to can help manage risk. For instance, if a fund is concentrated in financials, then interest rates are a crucial variable.

ROBO concentrates heavily on technology and industrials

Picture2_1b10c1a779.pngSource: Bloomberg, 27 May 2021

Which countries is the fund most exposed to?

ETFs that invest in global shares have become one of the most popular types of ETF. Yet going overseas comes with risks. It means investors are affected by exchange rates, for instance. Overseas companies (like Apple or Tencent), are traded and valued in their local currencies (USD and HKD).

Political risks can also come into play. This is especially true in the bond market, where political changes can directly impact a government's willingness or ability to repay its debts. It is also typically truer in emerging and frontier markets, where political systems can be more unpredictable.

ROBO is underweight US stocks and overweight Japan and Germany

Picture3_2ebc8a3a90.pngSource: Bloomberg, 27 May 2021

How are securities selected?

As ETFs evolve, their investment strategies are becoming sophisticated. New technology, like natural language processing, is giving ETFs the power to analyse companies in ways that were historically the province of expert managers. These days, ETFs can do things like scrape earnings calls with analysts to examine management’s strategy. Or parse companies’ financial statements to examine their balance sheets.

Investors should try and get under the hood of how ETFs select the shares or bonds they buy.

How are securities weighted?

Once assets are chosen, ETFs buy different amounts of them in a process called “weighting”. The most common weighting is called market capitalisation, where companies’ shares are weighted based on how big they are. The Commonwealth Bank – Australia’s biggest company – getting 8% of ASX 200 ETFs is an example of market capitalisation weighting.

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Other weighting methods include equal weighting—where all companies get equal treatment (as in our FANG ETF) and tiering – where assets are weighted in tiers, like a wedding cake, based on how relevant they are to an ETF’s investment strategy (as in our ROBO ETF).

How often does the portfolio rebalance?

ETFs periodically reset to ensure that they are sticking to their investment strategy. These resets are called “rebalances” or “reconstitutions”. They involve buying and selling shares so that the ETF stays in line with its index.

Some rebalancing on index ETFs is essential: without it, an ETF will fail to deliver its investment objectives. However regular rebalances of large portfolios can in some instances cause added transaction costs.

Investors should investigate how often the ETF rebalances.

Part 2 | Strength and Weaknesses