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

Morning all! I’m off to stay with some old friends in the Balearics for a few days, and I’ve no intention of keeping up with the Spanish until 4am and then rising to write a post for you at daybreak.

Come now, don’t be like that – it’s not easy doing this every Saturday for five years you know.

Okay, okay, here’s a few links I prepared earlier that I think you’ll find interesting.

Enjoy!

• The Eurozone crisis – A bulletin board post from a poster I hugely respect
• US unemployment truly awful [graphic] – Worse slump for generations
• Oaktree Capital Memos – Buffett’s faves, start at the top and work down
• Asset class correlations – It’s all bunk
• My barber is a millionaire – Darwin’s Money
• Stretching rubber band creates more value – Investing Caffeine
• Spending strategies in retirement – Oblivious Investor
• War is a racket – A bit old this one (from 1881!)
• Vanilla Ice real estate – Sadly not a joke

Like links? Subscribe to get them every Saturday. (Even when I’m on holiday!)

I often read comments from private investors – or even in magazines and newspapers – suggesting that to live off investment income you should choose your holdings according to when the income is paid.

According to this theory, a high yield portfolio ought to have some shares that pay dividends in January, some in February, some March, and so on, to spread the income over the year to meet your monthly spending needs.

The same holds – they say – for other sorts of investments. Most income trusts pay their dividends quarterly or twice a year, so the investor is urged to pick their trusts accordingly. Or you’ll hear buy-to-let property being touted specifically because the inflow of cash from rent will arrive on a monthly basis.

But this is a crazy way to live off investment income.

Firstly, you should not be relying on such income to arrive on a monthly basis like a salary. It’s too precarious. Rent can be skipped, dividends cut, and the interest on cash slashed.

Secondly, you shouldn’t be spending all your money every month anyway, hoping you can make it to the next dividend. There are many reasons to live off investment income, but a stressful life is not one of them.

Thirdly, you cannot afford to add the spurious requirement of ‘When will I get paid?’ to your selection process when designing your income portfolio. You need to focus on asset allocation, diversification, and other more important factors.

You may even want to own some assets that don’t produce an income at all, but will either need to be periodically sold down (for instance a gold ETF) or else that mature as a lump sum (such as an NS&I index-linked bond).

Finally, I’d urge people pursuing lifetime financial freedom to continue reinvesting some of their investment income after quitting work, at least early on. Again, monthly get-and-spend thinking works against that.

A better way to live off investment income

You need to decouple your income streams from your outgoings, in a methodical and modifiable way:

1. Set up a cash buffer account between your regular monthly spending, and your income-spewing engines.

2. Work out how much of your annual investment income you will/can spend. The rest of the money you will reinvest.

3. Load your buffer account with a very healthy float of money.

4. Direct all your investment income to be paid into the cash buffer account (by a proxy current account if need be) and set up a monthly direct debit out of the buffer and into your spending account. The monthly debit from the buffer is your permitted annual spending amount from step #1, divided by 12. This is the money you can spend each month!

5. Finally, as your buffer grows (because you’re taking less money out than you’re paying in) you occasionally reinvest the surplus back into your income investments.

Now, compared to spending your dividends and your other income the moment it arrives, this system does mean you’ll require a bigger investment pot – or else you’ll need to live on less money than you’d hoped. The cash buffer will gobble up a chunk of your funds, and the safety margin you’ll be reinvesting also cuts your monthly spending.

But the reward is a rock solid monthly income, infinitely greater piece of mind, and a portfolio chosen entirely on its merits that can easily be modified to accommodate lumpy investments such as maturing bonds or capital growth products, as well as non-investment income such as gifts from older family members, or piecemeal part-time work.

Tips on setting up your income pipeline

I have previously written about creating an income portfolio to replace your salary, so please do read that article for more on building your income portfolio.

Also, I am ignoring tax, since everyone’s circumstances vary. Needless to say, you should set up your income system in a tax-efficient way, using ISAs, SIPPS, and your annual capital gains allowance.

Here are a few other tips on designing your income regulator:

Keep at least a year’s spending in your cash buffer

I suggest you hold at least 12 months total spending in this buffer, and preferably more. That might seem incredibly tough, but in the mid-1970s and again in 2008 dividend income dived in real terms. Also, rent can go AWOL, interest on cash can be cut, and formerly rock solid vehicles like PIBS suspended. If you’re living off investment income, you need a safety net.

The cash buffer should be in multiple high interest accounts

Conceptually, it’s one ‘float’ of cash, but for insurance purposes you should spread your money between two or more banks. Take into account the maximum compensation per bank from the FSCS guarantee scheme (currently £85,000) but spread your money anyway – if one bank melts down you will still need to eat while you await your compensation. You may also need to employ multiple accounts to be permitted sufficient annual withdrawals at a decent interest rate.

The buffer should pay interest, and remember inflation

With 1-2 years worth of spending money in it, it’s vital you keep your cash in the best paying interest account you can find. Be prepared to move it when the rate is cut. Also, you’ll need to increase your total buffer with inflation every year. In the good times, the interest might handle this, but if not you’ll need to top up.

Spend less than you generate: Perhaps 75%

Just as it’s good practice to spend less than you earn when working, it is sensible to spend less than you can when living off investments. There are two good reasons. Firstly, you can reinvest the spare money to grow your income stream, which will help you beat inflation – especially vital with fixed income. Secondly, should a financial disaster strike and your income nosedive, you’ll hopefully not feel the pain.

(This might sound like a platitude to frugal Monevator readers, but in the real-world people would be thinking fancy cars, gym bills, three foreign holidays, and all sorts of other commitments. This second safety margin is especially important if you retire from work very early – there’s hopefully a long way to go!)

Flexibility with lumpy income

A helpful thing about this system is it’s able to accommodate all kinds of income streams with ease, including passive income, part-time work, annuities, inheritances, capital sales, and more. Just lob it all in the buffer and adjust as required.

Tweak and tack as she goes

After a year or two you can revisit your figures and adjust if you’re being too generous to yourself – or even too mean! If your investment income rises dramatically, you can consider increasing your spending. If it dives, dial down your monthly debit.

You’ll also need to rebalance your portfolio as usual, of course, and move towards safer fixed income investments as you age. You also might increase your spending as the final curtain draws near, unless you’ve heirs to worry about – or perhaps spend twice as fast, as the case may be!

If you’ve made your own plans to live off investment income (or you’re already doing so) then please share your tips in the comments below.