ETF Focus List: Top ETFs For Your Portfolio

Expense ratios, assets under management, liquidity, tracking difference and underlying holdings assessment are some criteria we use to select our ETFs.

Investors can invest in ETFs using several investment strategies, such as taking a core-supplementary portfolio approach and capturing trends and hedging

With the vast number of ETFs covering almost every market imaginable, constructing portfolios using ETFs are limited only by your own ingenuity.

Exchange traded funds (ETFs) have been in the investing mainstream for years. Since State Street released the first US-listed ETF in 1993, the ETF market has grown exponentially, with assets under management (AUM) exceeding USD 4 trillion in 2017. As the number of ETFs continue to grow, we’re excited to unveil another addition to our focus list series, the ETF Focus List to help investors with their ETF selection decisions.

Purpose Of The ETF Focus List

The ETF Focus List is not designed to be the be-all and end-all list of ETFs that investors can select for their investment portfolios. Instead,the list serves as a starting point for investors who are seeking a low-cost method to gain diversified exposure to markets, guiding them through the sheer number of ETFs that are available on various exchanges.

The ETF Focus List consists of 6 categories: Core Equity, Core Fixed Income, Regional Equity, Country Equity, Sector Equity and Commodities. Based on our selection methodology, we have meticulously curated a total of 42 ETFs, which we will review periodically to ensure that our selections remain current and relevant for all investors.

Investors can utilise this list as a source of idea generation, as a guide for their ETF selection decisions, or even to build an entire portfolio of ETFs from scratch. However, investors should note that the ETF Focus List is not tailored to an individual's risk appetite or investment style, and as such, not all of the ETFs are suitable for any one investor. Moreover, as most of the ETFs are denominated in USD, investors may be subjected to currency risk.

Selection Methodology

The ETFs on our focus list are selected based on both quantitative and qualitative factors. The quantitative factors used in our analysis are expense ratio, AUM, tracking difference and liquidity. Qualitative factors, such as the choice of index (how well it represents the broader market) and ETF replication method, are also incorporated into our selection criteria.

It is important to keep in mind that although the ETFs chosen using our selection methodology does not guarantee superior returns over its peers, they do however, have an edge over the rest based on the quantitative and qualitative criteria set out below.

1. Expense Ratio

Definition: The expense ratio is what you pay annually, to cover for the various operating expenses and management of the ETF, such as management fees, administration costs, audit and legal fees, custodian as well as marketing costs. They are expressed as a percentage of the ETF’s average net assets.

Generally speaking, the lower the expense ratio, the higher the total return. Thus, expense ratio is one of the most important criteria in our selection process. Table 1 below illustrates the impact that expense ratios have on total returns using a hypothetical investment of USD 10,000 compounded at 10% annually over the course of 5 years.

Table 1: Higher Expense Ratios Dampen Total Returns

If you had invested USD 10,000 in an ETF with a 0.5% expense ratio, the value of your portfolio after 5 years would be USD 15,742 (2.25% less than an ETF with a 0% expense ratio). A similar investment in an ETF with a 1.5% expense ratio will only be worth USD 15,036 (that’s 6.64% less than an ETF which has a 0% expense ratio). As the example above illustrates, even a small difference in expense ratios can significantly lower your returns over the long run.

2. Assets Under Management

Definition: Assets under management (AUM) is a measure of the total market value of assets an ETF holds. ETFs with large AUM have certain cost benefits. As the AUM of an ETF grows, operating expenses are spread over a larger asset base, thus reducing the total expense ratio. An ETF’s AUM is also indicative of its liquidity. ETFs with larger AUM tend to have higher trading volumes on average and are more liquid compared to their smaller AUM counterparts.

AUM also gives investors clues on the strength of the issuer, and consequently, whether the ETF is at risk of closure. Imagine paying commissions fees to invest in an ETF only to be told shortly that it will be closed. Hence, we prefer ETFs with higher AUMs as they generally carry a lower risk of closure. Besides, ETFs with larger AUM tend to be backed by larger issuers such as BlackRock, State Street and Vanguard, and these issuers are unlikely to go out of business.

3. Tracking Difference

Definition: Tracking difference is the difference between an ETF’s performance and the performance of its underlying index. Tracking difference is often negative, meaning the ETF underperforms the index. There are several possible causes of tracking difference, the most common of all would be expenses.

If an ETF has an expense ratio of 0.25%, theoretically you should expect the tracking difference to be within a few basis points of that figure. However, that is usually not the case. Most of the time the tracking difference can be higher or lower due to other factors such as currency hedging, cash drag, representative sampling and securities lending.

A small tracking difference is desirable as it ensures investors are paying to get identical exposure as the underlying market. As part of our selection methodology, we only select ETFs with an established track record of at least 3 years.

4. Liquidity

Definition: Liquidity is a measure of how easy or difficult it is to buy or sell an asset quickly without affecting its price. ETFs with high liquidity allow investors to react swiftly to changing market conditions. As the overall liquidity of an ETF is determined by its trading volume (secondary liquidity) and the liquidity of its underlying securities (primary liquidity), we consider both sources of ETF liquidity in our selection methodology (Chart 1).

The secondary liquidity of an ETF, or the on-screen liquidity, indicates the volume of shares traded between investors in the secondary market. The average daily volume (ADV) provides some indication of an ETF’s liquidity. While a higher ADV generally points towards a robust secondary market for a particular ETF, it does not paint a complete picture of its overall liquidity.

ETF shares are not finite, as they can be continuously created and redeemed whenever there is excess supply or demand in the market. In order for new ETF shares to be created, the authorised participant has to be able to purchase the underlying securities in the open market and deliver them to the ETF issuer, and vice versa. This creation/redemption process adds another layer of liquidity to an ETF, known as the primary liquidity, and is determined by the liquidity of its underlying securities.

Chart 1: Creation and Redemption Process Adds Another Layer Of Liquidity

5. Qualitative Criteria

In addition to the above-mentioned quantitative factors, we also consider qualitative criteria, such as:

- Choice of index (whether the index is a good representation of the broader market)
- Concentration risk or default risk (for fixed income ETFs) of the underlying holdings
- Physical vs synthetic ETFs, with a preference over the former as they hold the underlying securities of an index and are not subjected to counterparty risks.

As we take into account the above qualitative factors, the highest-scoring ETF based on our quantitative assessment may not necessarily be the ETF that we include on our focus list.

Investment Strategies Using The ETF Focus List

There are several ways investors can make use of our Focus List. In this section, we will highlight a few investment strategies investors can consider when incorporating ETFs into their portfolios.

Core-Supplementary Portfolio Approach

The concept of the core-supplementary portfolio approach to investing involves allocating investments into two portfolios.

Core Portfolio: The assets allocated to the core portfolio are invested in broader regions such as US, Europe and Asia ex-Japan, providing diversified exposure to global markets. These assets are held for the long-term and forms the foundation around which the entire portfolio is built.

Supplementary Portfolio: The assets in the supplementary portfolio are invested in higher-risk assets or geographical markets, and the investor has to closely monitor this part of the portfolio in order to take advantage of opportunities. This is where the investor has the flexibility to make tactical allocations to specific sectors, countries or even investment styles which he or she feels will outperform the market. The objective of the supplementary portfolio is to earn greater returns than those generated by the core portfolio, although it should be capped to a maximum of 20% of your assets to ensure that your portfolio does not become overly-aggressive.

Using the ETF Focus List, investors can construct their desired core portfolios using a combination of ETFs from the Core Equity, Fixed Income and Regional Equity ETFs. For the supplementary portfolio, investors can choose from the wide variety of single country, sector and even commodity ETFs available in our Focus List. An example of a portfolio constructed using the core-supplementary portfolio approach is presented in Table 2. Please note that the portfolio below is just an example, and is not meant to be interpreted as a recommended portfolio.

Table 2: Sample Core-Supplementary Portfolio

Capturing Market Trends And Hedging Using ETFs

Investors are constantly on the lookout for promising macroeconomic themes that will drive tomorrow's markets. By having a deeper understanding of these long-term trends and their investment implications, as well as determining the right investment vehicles to allocate their capital to, investors can increase their chances of generating above-average returns. As such, ETFs allows investors to gain exposure to certain market trends, without the need to pick individual stocks.

For example, the semiconductor industry has been one of the fastest growing industries in recent years, achieving a compounded annual growth rate (CAGR) of 7.6% for the period between 2012 and 2017. This strong growth rate is expected to continue, mainly driven by the rise in hardware spending for Internet Of Things (IOT) applications. The use of an ETF such as the VanEck Vectors Semiconductor ETF (NYSE.SMH) would be an appropriate instrument to play this trend, versus buying the stock of individual semiconductor companies where the risks are slightly higher.

Related Article: 3 Reasons Why You Should Invest In The Semiconductor Industry

ETFs can also be used for hedging. A good example of this would be the negative correlation between gold and equities, which has led to the common use of gold ETFs, such as the SPDR Gold Shares (SGX.O87), as a hedge against equity market volatility.

Final Remarks

The possibilities are endless when it comes to constructing ETF portfolios. The exponential growth of the ETF market has led to the creation of hundreds of new ETFs each year, covering niche markets which were previously inaccessible to investors. With the number of ETFs set to increase in the future, constructing portfolios using ETFs are limited only by your own ingenuity. While the ETF Focus List does not guarantee investment success, it is certainly a good place to start.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.