Updated: Mar 19, 2020
Exchange-Traded Funds or ETFs for short have become increasingly popular as more people embrace DIY investing strategies. The value of all assets held inside ETFs is nearly $4.5 trillion worldwide.
ETFs allow small investors with a limited amount of money to invest in a diversified basket of assets. When one share of Amazon costs $1,900 it’s impossible to build a diversified portfolio without large sums of money by investing in individual stocks.
ETFs can cover all manner of things from a stock index, to a particular currency to a sector of the economy. In fact, there are nearly 7,000 ETFs worldwide. For the purposes of this article (and in most of my writing), I will use the terms "ETF" and "index fund" interchangeably as index funds are the only type of ETF I invest in and am interested in discussing.
In this article, I'm going to discuss the four important factors I look for when buying an ETF.
1. Management Expense Ratio (MER)
An index fund has one job, to replicate the performance of a particular index. For example, an S&P 500 index fund is designed to replicate the performance of the S&P 500. That is the job of all S&P 500 index funds.
If all index funds have the same job of tracking a particular index, then the silliest thing you can do is to pay more than you have to for an index fund. That is where Management Expense Ratios (MERs) come into play.
An MER is the fee you pay to the fund which pays for all the costs of running the fund. MERs are a percentage of the money you have invested in the fund.
Let's assume the other three factors I'm about to discuss remain equal and I am left with deciding between two S&P 500 index funds; one fund that has an MER of 0.20% and one that has an MER of 0.02%.
Which should I choose?
Since these funds do the exact same thing, the only rational choice would be to pick the fund with an MER of 0.02%. Why would I pay one penny more than I have to when deciding between two products that are virtually identical?
Whatever type of index fund I am considering, the first thing I look for is the MER of the various funds that track that index. If I am looking for an index fund that tracks the Canadian stock market, I pull up the various Canadian equity ETFs and start comparing the MER of each fund.
Staying with the theme of costs, this has less to do with the ETF it's self and more to do with the online broker you buy the ETF from. Some online brokerages charge a commission every time you buy an ETF. These fees are often around $5 or more per transaction.
So, if you spent $100 buying ETFs you could be charged $5 for that transaction. This can seriously eat into the returns of smaller investors who are investing small amounts of money at a time.
For that reason, before you start your DIY investing journey you should take your time to find the right online broker that allows you to buy ETFs for the lowest price possible.
3. Fund structure & withholding taxes
No matter, what country you live in if you are investing in stocks or ETFs that hold stocks from foreign countries, you are likely going to be paying withholding taxes.
Put simply, if a foreign company pays you a dividend a portion of that dividend is taxed before it ever gets to you by the government of where that company is located.
Investors outside of the U.S have two levels of withholding taxes that they need to be aware of.
Since I am Canadian, I'll explain the two levels of withholding tax in the Canadian context. If you are not American or Canadian, a similar withholding tax issue will likely be a factor for your investing.
Level 1 (L1) withholding tax: These are withholding taxes levied by a foreign government when a Canadian investor receives dividends from a company in that country.
Level 2 (L2) withholding tax: This is an additional withholding tax (typically 15%) applied by the U.S government. Level 2 withholding tax applies to dividends paid to a Canadian investor by a Canadian-listed ETF that owns a US-listed ETF. You still have to pay level 1 withholding tax in addition to this 15% withholding tax to the U.S government.
Depending on the structure of the ETF, I may have to pay level 1 or level 2 withholding tax when investing in international index funds. That is why it is so important to know if the ETF I am considering investing in holds stocks directly or holds a U.S listed ETF. That will be a huge factor in whether level 1 or level 2 withholding taxes apply.
For all Canadian investors, the following infographic acts as a free "cheat sheet" to help you determine what type of ETF structure that works best for you and where the smartest place to hold each type of ETF is.
4. Tracking error
The final important factor I look for before buying an ETF is it's tracking error. Tracking error measures the fund's accuracy in tracking it's underlying index. It is the difference between the fund's performance and the performance of the index it seeks to track.
Returning to the example of an S&P 500, the tracking error tells us how closely the index fund mirrors the performance of the S&P 500. If the S&P 500 returned 10% in a given year and my S&P 500 index fund had a 9% return the tracking error would be 1%.
Since the entire point of index funds is to track the performance of an index, I look for funds that have the lowest tracking error as they are likely to give me a reliable result.
These are four factors I look for when buying ETFs. These are not the only factors, to be sure, however, they are the ones that I find to be both important and easy to verify. For that reason, I always compare how various ETFs with the same objective measure up when it comes to MER, trading commissions, withholding taxes and tracking error.
What do you look for when buying an ETF? Are there any important factors you think I have missed in this article? Let me know in the comments.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.