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5 Simple Steps to Choose the Best ETFs to Invest In

There are more than 50 exchange-traded funds (ETFs) listed on the Singapore stock market. With a myriad of ETFs to choose from, how do we pick the best ETFs for ourselves? Fear not. In this article, I present five simple steps to select the best ETF out of the rest.

1. The type of ETF

Firstly, you have to determine the type of ETF you wish to invest in. Do you want to diversify your holdings across the best dividend stocks listed in the region? Or would you rather diversify across the big local companies? Your investing preference would determine the theme for your ETF. You can check out the article here to understand the various types of ETFs available on the Singapore stock market.

2. Expense ratio

The expense ratio is the annual fee that ETFs charge their unitholders. The fee includes costs such as administrative, compliance, distribution, management, and other related expenses. The expense ratio can be found in an ETF’s prospectus. For example, the SPDR STI ETF (SGX: ES3) has an expense ratio of 0.3% per annum.

ETFs generally charge a lower fee than unit trusts, making ETFs an attractive passive investment. The low fee makes a lot of difference over the long-term. Warren Buffett also recommends investing in low-cost index funds instead of ploughing our money into hedge funds for cost reasons.

3. Tracking error

Tracking error is the difference between the performance of an ETF and its underlying index. This error occurs for various reasons. For instance, the cost of buying and selling of securities are charged to the ETF, and this expense eats into the ETF’s performance relative to the underlying index that it tracks. Sometimes, dividends which are received, but not yet distributed to investors may cause tracking error as well.

We should always go for an ETF with a low tracking error. This criteria ensures that the ETF tracks the underlying index as closely as possible, giving us the closest possible return of the underlying index.

The tracking error can be found in an ETF’s prospectus or fact sheet.

4. Liquidity and spread

ETFs have market makers to provide continuous bid and ask quote to ensure availability of prices and liquidity. However, there can be times when the market makers are unable to provide a continuous quote for the ETF. As a result, buyers or sellers may not be able to buy or sell an ETF promptly at a reasonable price.

We should always ensure there are sufficient liquidity and tight bid-ask spreads when investing in ETFs.

5. Keep it simple, Simon

The simplest ETFs are those that offer a direct replication of the underlying index by investing in the index’s constituents. The method of replication can be found in an ETF’s prospectus.

There are some ETFs that offer leverage by using derivative instruments to amplify the returns of an underlying index. For example, there are ETFs that promise three times the return of the index it tracks. While it sounds promising, such an ETF can also produce three times lower returns when the index turns south. Such ETFs are risky and are not suitable as long-term investments. ETFs that have the word “ultra” attached usually imply leveraged ETFs.

Sticking with simple, passive ETFs is a better way to preserve wealth over the longer term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.