What to consider before making an ETF investment

Exchange-Traded Funds (ETFs) are one of the most popular investment options available today.

They give investors easy access to many different assets without the high price tags seen in actively managed funds. But as user-friendly as these products are, finding an ETF investment for you is going to take some time and consideration. Here are a few things you should consider before making an ETF investment.

What is an ETF?

An ETF (exchange-traded fund) is a fund that owns a group of assets such as stocks and other securities. When you buy shares of an ETF, you buy a piece of the portfolio, which can include any asset the ETF holds.

So why do people invest in ETFs? Here are the top three reasons. ETFs can help diversify a portfolio, increase flexibility and provide a level of transparency and liquidity that actively managed funds just cannot provide. You can purchase and sell shares throughout the trading day, which is another bonus.

Define your investment goal first

When considering whether to invest in an ETF, the first step is to define what you’re looking to accomplish. Remember, not all ETFs are created equal, and if you don’t have a goal, the ETF you choose might not meet your expectations.

The investor saving for retirement, for example, will likely focus on broad-market ETFs, which tend to offer long-term growth prospects. Conversely, the income-minded may consider bond- or dividend-focused ETFs. Investors with regular monthly contributions may also look to market ETFs.

Whatever your goal, it should be at the centre, and you should remember it whenever building your ETF portfolio. If you don’t have an investment goal, you’ll never really know if any particular ETF investment is right.

Think carefully about diversification

One of the main reasons to buy an ETF is diversification. But not all ETFs offer the same level of diversification.

Broad-market ETFs spread your investment over hundreds, sometimes thousands, of different companies. This diversification can reduce the impact of one company having a bad year.

Sector and thematic ETFs can pose a higher risk. They concentrate on a single industry or theme, which can give your portfolio extra growth potential. However, funds like these can also be riskier. For most investors, a broad market ETF serves as a better building block for a long-term portfolio.

Know your costs, fees and liquidity

Even small costs can add up over time. Look at underlying expenses when comparing ETFs, including the expense ratio, and any additional management or performance fees.

Liquidity is also something to keep in mind. Highly liquid ETFs usually have tighter ratios in trades, which can make it both easier and less expensive to trade. While ETF investing fees are usually lower compared with most traditional investing methods, a cost comparison remains an essential step in making a choice.

Accumulating vs distributing ETF

You should also know the difference between an “accumulating ETF” and a “distributing” ETF.

An accumulating ETF accumulates any dividends paid into the fund, so they can help you to benefit more through compound interest. This makes them ideal for somebody looking to maximise their long-term growth.

A distributing ETF will pay any dividends out to you. For anybody looking to take a regular stream of income, this will suit you. You’re not going to miss out on more growth by the fund reinvesting your dividends.

Currency & domicile/tax considerations

Some ETF investments are made in other currencies. When there are fluctuations in the forex rate, this can have a big impact on your investment. It’s important to know how much of an ETF’s exposure is made up of other currencies.

Similarly, where an ETF is domiciled can also influence regulatory and tax considerations. Tax treatment can vary between different countries, so you might want to do some further research before investing.

Common mistakes made by ETF investors

One of the most common errors is buying a particular ETF because it’s popular or has experienced a run of good performance. Just because a particular ETF has done well in the past, it is no guarantee that the ETF will be a top performer moving forward.

Another is using multiple funds that own many of the same underlying investments (i.e. owning an S&P 500 fund along with a domestically focused Large Cap Growth fund). This creates unnecessary risk and can actually concentrate exposure to a single market or asset class. Individuals can also underestimate the risk in ETFs because they incorrectly think that owning a large number of stocks will smooth out all volatility in the marketplace.

Taking the time to understand objectives, costs, diversification, and structure can help investors avoid these common blunders…

How to build a smarter ETF portfolio

There is no doubt that ETFs can represent a useful and cost-effective way to generate wealth, achieve retirement goals, and accomplish passive investing with ease. However, this success largely hinges on how investors go about uncovering their risk profile, investment goals, time horizon, and asset allocation requirements. Ultimately, investors should avoid getting caught up in the “blogosphere” hype, as finding the right fund is more of an individual process. Take the time to carefully compare funds, keeping the above features in mind, and jump into your first ETF investment with purpose and a long-term outlook.