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ETF Selection (3 of 4).

How does an Individual Investor choose the right ETF?

As always, it’s the process itself that delivers the majority of value (performance and risk management) so the starting point is the process that works for any investment selection.

– Revisit your Investor Profile to define/refine goals, risk tolerance and time frame … as documented in your …
– Investment Policy Statement … which produces your Asset Mix Policy. Then … (and only then) …
– … begin Portfolio construction work by screening the ETF universe. Search for the ETF that will fulfill the requirements of your Asset Allocation policy (The job description)  

Then, when you know what you’re looking for … consider:

ETF selection criteria.

1 – Exposure. Does the ETF provide asset class, region, sector or industry coverage? I.e. is there fidelity to your strategy? Does the ETF fit the job description?

2 – ETF composition. Is the number of securities in the ETF adequate? Do the weightings of the individual holdings allow for prudent diversification? Or is there too much concentration?

3 – Cost / MER. The Canada Pension Plan costs are about 0.43%. Institutional investors pay ~0.25% for bonds, ~0.60% for stocks and ~0.84% for real estate. ~0.60% for a diversified portfolio. Individual investors can be in the same range with an ETF portfolio. The CORE ETFs will cost near zero. Eg. XIU is 0.17%. VV is 0.12%. The more complex ETFs cost more. See CPP costs.

4 – Volume. Daily volume of securities traded indicates liquidity. XIU is the most liquid ETF in Canada.

5 – Exchange. If you want access to inexpensive, non-Canadian exposure, look to Vanguard (first). Vanguard ETFs trade on U.S. exchanges. (Just like IBM, for example). Overseas exchanges? Well, IF your discount broker offers this service at all, it is likely to be prohibitively expensive.

6 – Track record / Tracking error. The simple ETFs all track their benchmarks very closely. The more complex the ETF, the larger the tracking error is likely to be.

Simple is usually best.

Armed with criteria to evaluate an ETF, the sort and selection … using an ETF screener tool … should be easy(er).

Next time?
ETF Selection (4 of 4).
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan

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