Which ETF to Choose? A Simple Approach to Make the Right Choice

Introduction

The famous ETFs (Exchange Traded Funds), which I am sure you have already heard of if you have started investing in the stock market. I have already talked about them myself in this tutorial if you remember well, without mentioning which ETF to choose. They have become extremely popular and allow you to easily access diversification in an index, a sector, or a specific theme, all without having to individually buy each stock. And as I have already told you, diversification is important!

Okay, that's all great, but which ETF to choose? Indeed, it is obviously preferable not to simply select any random ETF, but to find the one that perfectly matches your strategy and your investor profile. In this tutorial, I propose to go through the different steps to help you make the right choice:

• Define your investment objective: do you prefer a broad market, a specific sector, or a particular geographic area?
• Evaluate the diversification offered by the ETF: perfect for reducing the overall risk of your portfolio.
• Compare the management fees of ETFs: this impacts net performance.
• Check the market liquidity for the ETF: or simply how to ensure fast and efficient execution.
• Understand the replication method used by the ETF: physical vs synthetic.
• Choose between capitalizing or distributing dividends: which will impact your returns.

No worries if you didn't understand everything just by reading this summary. I will now go into a bit more detail to help you best answer our famous question: "Which ETF to choose?".

How does an ETF work?

Simply put, they are baskets of stocks or bonds (for the small note, a stock means owning a share of a company. A bond means lending money to a company in exchange for interest). This basket of stocks replicates the performance of a benchmark index, such as the CAC 40 (for France), the S\&P 500 (for the United States), or even the Nasdaq. If you buy a single share of an ETF, you are indirectly investing in all the companies that make up that index (yes, all of them). Quite interesting, isn't it?

"They are baskets of stocks or bonds, which replicates the performance of a benchmark index. If you buy a single share of an ETF, you are indirectly investing in all the companies that make up that index."

ETFs, just like a regular stock, are traded continuously on financial markets. This means that their price fluctuates throughout the day based on supply and demand, but that's not all! The value of the stocks (or other securities) that make up the ETF also has an impact. Their operation is quite simple:

• Real-time quotation: each ETF has an ISIN code and a ticker (for example, "EWQ" for an ETF on the MSCI France index. It is an index that groups together the main large French companies, for those who are curious).
• Automatic allocation: as soon as you invest in an ETF, the fund issuer automatically takes care of replicating the exact composition of the tracked index. You don't have to manage anything manually!
• Reduced fees: unlike traditional funds that are actively managed by a professional, the passive management of an ETF allows for limiting annual fees.

You can see that the last two points are real advantages of ETFs, but they can also be appreciated for other reasons. First of all, they are very accessible, meaning that a simple order on the stock exchange allows you to invest in an entire geographical area or sector. What better way to diversify well? And this additional diversification is immediate: even with a small amount, you can spread your risk over several dozen or even hundreds of companies!

They are also transparent, as the composition of their portfolio is generally public and regularly updated. And finally, they are extremely flexible, as there are today thousands of ETFs covering almost all possible and imaginable themes. In short, you will have understood that ETFs are still very advantageous.

But how to know which ETF to choose?

1. Define your investment objective

You want to make an ETF choice, but do you know your investment objective?

• Broad Market: If you want to invest in a global market, nothing is better than opting for ETFs that track recognized indices, such as the S\&P 500 or the MSCI World. They include shares of many companies spread across different sectors and countries, perfect for significant diversification!
• Specific Sector: Are you a fan of a particular sector, such as technology, renewable energy, or healthcare? That's great because there are specialized ETFs available. For example, the "Invesco Solar" ETF focuses on companies in the solar energy sector.
• Specific Geographic Area: If you are more interested in a specific region or country, that's also possible. You can find ETFs dedicated to emerging markets, Europe, or even other countries like China or Japan.

2. Assess the Diversification Offered by the ETF

No need to repeat it: diversification is essential in reducing the overall risk of your portfolio. To know which ETF to choose, try to assess how many and what types of assets are included in the fund:

• Number of assets: An ETF that includes a large number of companies = better diversification (in general).
• Sector allocation: Does the ETF include companies from different sectors? For example, some specialized ETFs may have a high concentration in a single sector. So if the sector performs poorly, the ETF will perform poorly. It's as simple as that.
• Geographical diversity: An ETF exposed to multiple regions of the world can help mitigate risks specific to a market (in case of a political crisis in a country, for example).

To make the right choice, nothing beats comparing several ETFs and analyzing their composition.

3. Compare the management fees of ETFs

Like anything else, managing an ETF is not free. There are (unfortunately) management fees that can have a significant impact on the long-term net performance of an ETF. Even fees that seem minimal to you can accumulate and reduce your returns over time. But how do you compare fees?

• Examine the expense ratio: that is, the percentage of assets under management that are used to cover annual fees. A general rule of thumb is that a lower ratio is preferable.
• Compare several similar funds: for example, if you are considering two ETFs tracking the same index, you can compare their respective management fees.
• Pay attention to less visible fees: in addition to management fees, there are also costs that are not always visible. Notably brokerage fees or the difference between the purchase and sale price. These fees can reduce your gains, so keep them in mind.

4. Check the market liquidity for the ETF

Liquidity, very briefly, corresponds to the ease with which one can buy or sell an ETF quickly, without the price changing too much. Sufficient liquidity allows you to place your orders easily and at the best possible price.

• Quick execution of orders: Is there a significant delay in buying and selling shares? If so, the ETF is not liquid.
• Slight difference between buying and selling prices: Liquid ETFs generally involve a small difference between the buying price (offer) and the selling price (demand), which also reduces transaction costs.
• Price stability: ETFs with high liquidity tend to have less abrupt fluctuations in their prices.

To check the liquidity of an ETF, you can look at several factors such as (1) the average daily trading volume, as a high volume generally indicates that it is easy to trade this ETF. (2) The market capitalization of the fund, since ETFs with a large capitalization are often more liquid. And finally (3) the difference between the buying price and the selling price, called the bid-ask spread (another complicated term for not much), where a narrow spread is a good sign of liquidity.

What is the replication method used by the ETF?

Replication is simply how an ETF tries to copy or track an index. When you hear about the replication methods used by ETFs, there are two main ones:

• Physical replication: this method involves the ETF actually buying the securities that make up the index it tracks. For example, an ETF that tracks the CAC 40 will buy shares of the 40 companies that make up that index. At least with this method, you know exactly what you are investing in.
• Synthetic replication: here, the ETF does not directly hold the shares of the index it tracks. Instead, it uses what is called a derivative (a financial contract, basically) to achieve the same performance as the index. This method can be useful for reducing certain costs or accessing more complex markets, but it is sometimes seen as less transparent. It can also carry some risk if the contract does not perform as expected.

Capitalization or distribution of dividends?

The last thing to know is that when you select an ETF, you also have the choice between a accumulating fund or a distribution of dividends:

• Accumulating ETF: The dividends generated by the underlying stocks are automatically reinvested in the fund. This can potentially increase the value of your investment over time.
• Distributing ETF: On the other hand, here the dividends are paid directly to the investors (i.e., you), providing a regular income stream. This type of ETF may be preferred by those looking to obtain a regular passive income, such as retirees.

Choosing between these two options obviously depends on your personal investment strategy. To put it very simply, accumulating ETFs can be more advantageous for long-term investors focused on capital growth. On the other hand, those seeking regular income may prefer distributing ETFs that pay out their dividends. It all depends on you.

Conclusion

I hope I have now answered our famous question: "Which ETF to choose?". I know very well that selecting the optimal ETF for your portfolio can seem complex, but like with all the other tutorials so far, a little research and time is all you need.

By following the simple approach of this tutorial, especially the information in section 2, I believe you have all the cards in hand to make an optimal selection of an ETF that perfectly matches your investment objectives and investor profile. Remember that each decision should be made taking into account your specific needs and risk tolerance. See you next time!