Analysing the ETFs on your watchlist

Past performance is no indication of future performance

Choosing shares based on how much they have increased in value in the past is another case of emotions over-riding logic. Why? Today’s share prices are largely based on the value investors expect to get from them in the future NOT what they’ve got in the past.

There are a lot of factors that impact investor expectations: Global trends, technology changes, governments, laws and emerging industries. Remember Blockbuster? If you had invested in Blockbuster in the early-2000s based on past performance, you probably would have lost a lot of money over the next decade as they went out of business. Blockbuster failed to adapt quickly to industry changes like the rise of subscription-based service models and online streaming, and all of its stores were closed within 10 years of its peak.

In contrast, Netflix also started out by renting out physical DVDs to people and charged per rental, but they quickly adopted a subscription model when consumer behaviours changed, and were quick to launch online streaming once the technology was there to do so. They were able to succeed where Blockbuster had failed largely because of their ability to adapt to new trends and technology.

Feels like a lot doesn’t it?

But, it’s really quite simple. Let’s go through them one by one, using some of the ETFs we mentioned on day five to help illustrate the things you need to consider:

The composition of the fund (# of companies and type) is important

For beginners, broad is best

As your confidence and investments grow, you’ll learn about more and more investment options.

However, if your goal is to build a basic portfolio and the easiest way to do that is to invest in broad ETFs called passive Index Funds. We’ve actually talked a lot about these already, but let’s do it again with jargon.

Jargon alert: What is an Index fund?

• Index: An 'index' is a categorised list of investment options, e.g. 'the largest 500 companies on the US share markets', or 'the 10 companies with the highest dividends on the NZX'. These lists are created and managed by companies like Standard and Poor's (S&P).
• Index fund: Because you can’t actually invest in an index (it’s just a list), fund managers create passive funds that aim to 'track' or mimic an index. Companies like Vanguard and Blackrock create funds like the Vanguard S&P 500 Growth ETF and the SPDR S&P 500 Growth ETF. Both track the same S&P 500 index.
• Passive: A passive strategy means the fund manager doesn't make active investment decisions to try to get better returns than an index; instead they spend their time ensuring their fund matches an index as closely as possible. 

Buying shares in ETFs that track a broad index (i.e., an entire share market) gives you the most diversification. As we’ve learned, diversification lowers your risk by spreading your eggs (money) over many baskets (investments). It means you are banking on the long-term success of things like an entire country’s economy, rather than on the success of a niche industry like robotics, or a single company.

Tracking an index: more work than it seems

Because passive Index Funds aim to track an index, the job of the fund manager is to always try to mimic the index instead of using their expertise to try to ‘beat’ it. They still have to buy and sell investments daily to ensure the fund continues to mirror the index its following, so passive fund managers still do a fair bit of work!

The performance of the fund (aka how much the fund increases in value over time) is dependent on how well the fund manager mimics the index. Their ability to do this is called the ‘tracking error’, which is how far off their percentage return is from what they’d have if they exactly mirrored the index.

Let’s compare 3 of the ETFs we mentioned yesterday. They all track the same S&P 500 index, which has had an average compounding return of 10.7% over the past 30 years. However each has different tracking errors. If you had invested $1,000 in each fund, this is how they would compare over a 5 year period:

Expense ratios: Finance jargon for fees

We’ve already talked about how all ETF providers charge fees, just like your KiwiSaver provider does. The fees are referred to as the ‘Expense Ratio’. The expense ratio tells you how much it costs to cover the operation and admin costs of running the fund, and is shown as a percentage. The average expense ratio for an ETF is about 0.44% (KiwiSaver average is about 0.7%).

Index funds usually offer the lowest expense ratio

Because Index Funds just aim to track an index like the S&P 500, investors don’t have to cover the high costs of expert stock pickers (who don’t always beat the markets). Combine this with the benefits of scale for some of the biggest Index Funds, and you’ll see expense ratios that drop well below the average.

It’s important to remember that even if an ETF has very low fees, if it doesn’t closely track the index, another fund tracking the same index may be a better option. This is because it may deliver better returns, even taking into account higher fees.

Let’s compare those same 3 ETFs again, and this time, add fees into the mix:

Once again, these are the world’s biggest ETFs, so the difference isn’t huge… But you start to build a picture of how tracking errors and expense ratios work together to determine your returns.

More money, fewer problems?

You know how we said following the crowd is a bad way to invest? Well, there’s one exception to that when it comes to ETFs. You should consider funds with net assets (total amount of money invested in the fund) of at least $10 million; lower than that may mean not enough people are investing.

Who cares? Well, you do. This is because you want other people to trade with when you decide to sell and just like with Trade Me, it’s hard to sell when no one is buying. Looking at the same three funds, all easily meet the ‘over $10m’ rule of thumb with net asset values of over $350 million.