So, you decided to invest in an ETF (exchange-traded fund).
You’ve heard of the many benefits, such as broad diversification, convenient trading, low investing fees, and most importantly: simplicity!
But, there happens to be one thing that isn’t as simple; investing in an ETF can be intimidating when there are literally hundreds of options.
Luckily, I have a beginner’s guide to investing in an ETF in 3 easy steps, with the basics covered for you right here in steps 1 and 2.
Lets say you already narrowed it down to an ETF that tracks the S&P 500. How would you determine which is the best option when they all consist of basically the same stocks? Step 3 has you covered by running through some key technical aspects that can help you find the most attractive option!
3 Fundamental Steps to Investing in an ETF
1) An ETF Risk Level that Matches your Investing Style
This is the single most important thing to consider before choosing an ETF, or any investment for that matter.
How much risk can you bear to take? More aggressive investors would be fine with an ETF that holds all equities. If you’re on the conservative side, you can get an ETF that holds bonds. There are also choices for “balanced” people that find themselves in the middle; Buy 2 passive ETF’s (one bond, one equity) or find an active ETF that matches what you want!
Do you have no idea what your investing style is? Not a problem! Check out this quiz to find your investing style.
Aggressive = Equity ETF (stock index)
Conservative = Fixed Income ETF (bond index)
Balanced = Balanced ETF, or both Equity and Fixed Income
Passive vs. Active Management
It is no secret that I am a fan of investing with low cost passive ETF’s. I like it so much that I even wrote on why you
should consider passive ETF’s as your first investment!
In case you need a refresher, these funds have very low fees since the management doesn’t make any big choices. All they do is track a benchmark. Based on your result in step 1, you could choose an ETF that tracks a stock index (for aggressive) or a bond index (for conservative).
However, I would not completely write off all active ETF’s. There are plenty of great choices hidden among all the mediocre ones. This is why we screen ETF’s!
If you choose an active ETF you will have to analyze the ETF more in-depth. The holdings of the fund will be different than the benchmark since it is trying to “beat” the benchmark. There are also some ETF’s that mirror mutual funds but with lower fees than the funds.
It is worth noting that active ETF’s are more of a Canadian thing; 13.7% of Canadian ETF assets (by dollar value) are actively
managed, compared to just 1% in the US, according to this article.
2) Choose The Region You Want to Invest In
One main part of choosing an ETF is geography. One amazing thing about ETF’s is they make it so easy to invest in companies worldwide! Every region in the world has one index or many indices which track and measure the region’s broad economic performance.
Brief refresher: an index is something that measures the performance of a category of stocks.
You may have heard of them on the news, especially American ones such as the Dow Jones Industrial Average or the S&P 500. Here is an example of how geography and indices meet: if you choose an Asian index, it’ll give you nice exposure to the Asian market without having to actually buy stocks in China, South Korea, etc.!
Another important factor is industry sectors. You can find an index for a specific sector such as finance, healthcare, and more. Even if you choose the overall market, you still need to take sectors into account! This is because certain countries have a large proportion of big companies in certain fields, as you can see in the above photo.
The USA has the technology giants (Apple, Amazon, Microsoft, etc) forming a large part of the stock market, while north of the border in Canada, the finance sector dominates (Royal Bank, TD, BMO, etc). This basically means investing in the USA = investing heavily in tech, and investing in Canada = investing heavily in banks. It isn’t a game changer, but it does help to be aware of where your money is!
3) Look at These 3 Technical Aspects
The third step to investing in an ETF is to look at the 3 technical aspects of MER, discount/premium, and bid – ask spread.
At this point you should have a few alternatives you are comparing! ALL should be at least looked at when choosing an ETF.
It’s good to know that MER is arguably THE most important of the 3 “aspects” I am listing. The reason being is that it has a continuous effect on the cost of your investment. The other 2 only drag you down when buying and selling. However, they still need to be accounted for since buying/selling costs add up over time!
Management Expense Ratio (MER)
The MER is the portion of the fund’s value which is taken to cover the fund’s management fees & other expenses (taxes, fees to other companies, etc.). The lower the MER, the better!
It is important to note that the MER has already been accounted for in the prices, so you do not need to deduct anything when buying or selling.
Example: If an index increased by 10% in 2017, and your fund’s MER is 0.1%, then your ETF’s return would’ve been shown
to you as 9.9% (10 – 0.01).
NOTE: MER is NOT the same as Management Fee!
This is super important when you are comparing different ETF products. The Management Fee is directly taken by the fund management as their “costs”. It is included in the MER, but is not all of it! The MER will always be equal to or larger than the Management Fee.
Long story short, for the basic comparisons you are making, MER is the number you need to watch when choosing an ETF.
Discount / Premium
The discount/premium of an ETF fluctuates over time. It is basically taken from comparing the “share price” of the fund to the “NAV per share”.
What is NAV?
If you google search it, you’ll end up finding the rapper… so it is better if I just tell you here!
NAV stands for Net Asset Value. It is the value of the assets (in this case, the ETF’s assets) after taking away expenses. The NAV per share is basically the value in dollars of 1 share of the fund. When you buy shares of an ETF on the stock exchange, one would think you would pay the same as the NAV, since that is exactly what it is worth, right?
Well, you are wrong! This is where discounts and premiums come in. There are so many factors affecting it (mostly supply and demand) and this is an article for another time. All you need to know is this:
Discount = When the ETF is being sold BELOW the NAV, measured in percent. This is literally the same concept as a sale/discount in a store!
Premium = When the ETF is being sold ABOVE the NAV, measured in percent. Think about how Air Jordan’s can resell for more than what they are worth. This is a premium!
Obviously, buying an ETF at a discount is better!
Bid – Ask Spread
This is the last key aspect you need to look at for evaluating an ETF. Basically, it measures how far apart the buying and selling prices are for the ETF. Like anything, people try to buy stuff for less than its value, and sell it for more than its
value. The spread is usually measured in a percentage of how far apart the 2 prices are.
Bid – ask spread is a great indicator of one thing – Liquidity!
Liquid investments are great. It is easy to find a buyer or seller, and buying/selling prices stay closer to the actual share price, meaning you keep more of the money you earned investing. This is something else that can be elaborated on
in another article. A lower spread means higher liquidity, which is exactly what we want when choosing an ETF!
Summing it Up
After reading this, you should have learned the following:
- Know what your investment style is
- How geography and industry sectors are involved in choosing ETF’s
- Know the significance of MER, Discounts/Premiums, and the Bid – Ask Spread
If you are confident in your understanding of the above 3, then what are you waiting for?
Time to get started investing in an ETF!
Check out Dan’s blog at Early 20’s Money.
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