How to choose the best index trackers #4: ETF-only features

Anxiety was the standout feature of my early adventures in choosing Exchange Traded Funds (ETFs).

Anxiety laced with confusion:

How do I know which of the hundreds of cryptically named funds to pick? What if I waste my cash on a lame horse that’s about to be shot?

Experience soon calmed my newbie nerves. Experience and a checklist I use to help me choose the best index trackers more quickly.

My checklist, like Ancient Gaul, is divided into four parts. Today’s final part scrutinises the ETF-only features to watch out for when you decide that only an index-tracking vehicle that’s spooking global regulators will do:

Here’s what to look out for.

Check the bid-offer spread

The bid-offer spread refers to the fact that it costs you more to buy your ETF on the exchange than you’d get for selling it. The difference is the spread – a source of tidy profits for the middlemen that make the market.

The spread is a cost of trading, so keep it as low as possible. The best funds will only weigh you down by a few basis points – the worst by several hundred!

Check the bid-offer prices of rival ETFs on the website of your broker or ETF provider. Spreads tend to bump about, so watch it for a few days to get a good fix.

A spread greater than 20-30 basis points (0.2 – 0.3%) is heading into the luxury price bracket when it comes to ETFs.

Broker commission

Bear in mind the cost of broker commissions when comparing ETFs with index funds.

You’ll pay a broker’s commission every time you buy and sell an ETF. You can avoid dealing charges on funds if you choose certain percentage fee brokers.

Aim to keep the commission under 1% and ideally no more than 0.5%.

Buying at NAV

You’re up there with Alan Sugar if you can buy an ETF at a discount to its Net Asset Value (NAV) and sell it at a premium. Essentially, you’re buying the ETF for less than its underlying assets are worth, and selling it for more!

Conversely, buying at a premium and selling at a discount is the work of a first-round Apprentice failure who only took part to further their ‘media career’.

In practice, NAV discounts and premiums aren’t usually a big deal for long-term investors who trade in the largest, Niagara-liquid funds – you can normally count the divergence from NAV in pennies.

But yawning gaps can open up during extreme market conditions. Some Japanese ETFs were trading at a premium of 8% to NAV in the aftermath of the tsunami. Standard practice should be:

• Avoid trading during a market crisis.

• Compare the ETF’s market price to its NAV.

• If the gap is wide then aim to buy at a discount and sell at a premium.

Number of market makers

Market makers are the ETF middlemen that marry up buyers and sellers on the stock exchange.

They provide the bid-offer quotes for the ETF and ensure its liquidity. The more market makers an ETF has, the more competition between them narrows the bid-offer spread.

Four to five market makers is champion. You’ll usually find the market makers listed on the ETF’s website.

Daily trading volume

A large trading volume isn’t just a way for boastful ETFs to intimidate each other in the locker room – it’s also used by some as a measure of ETF liquidity.

A high trading volume indicates that an ETF is easily traded because it has many buyers and sellers. This should tighten the bid-offer spread and help the ETF remain liquid during bouts of market turbulence.

You can hunt down the trading volumes of similar ETFs on the London Stock Exchange website.

Look at the total value of the trades (in the prices and trades tab for each ETF) to account for the affect of higher share prices on volumes. The more money that flows, the more liquid the ETF (in theory).

As with bid-offer spreads, check back on the data over a few days to get a feel for an ETF’s performance.

In conclusion

None of these more minor factors trump choosing the right index to track in the first place, nor picking an ETF with a low tracking error and TER. But they can help narrow your search and relieve the agony of choice.

Take it steady,

The Accumulator

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How to choose the best index trackers #3: Overlooked stuffHow to find index funds