How to choose an index fund such as an ETF

Categories Investing
How to choose between index funds

If you have decided to invest in a precise stock market index, you first have to choose the stock market index. And once you have chosen an index to invest in, you will have to decide through which index fund you are going to invest in this index. For this, you can choose either a mutual fund or an Exchange Traded Fund (ETF). For popular indexes, there will be a large choice of index funds replicating the performance of this index.

Even if you only choose popular funds for a precise index, it will still be difficult to choose. As you will see in this article, there are many things you can take into account when you compare two index funds. The most important remains the price as most people know. But there are other points you can use to compare two index funds. And some of these points are definitely not obvious.

In this post, we are going to see all the things you can look at when you need to choose an index fund, whether it is a mutual fund or an Exchange Traded Fund (ETF).

Total Expense Ratio (TER)

The Total Expense Ratio (TER) of an index fund is probably the most important metric you need to look at! In some cases, it is simply called Expense Ratio (ER). Since you are comparing two funds that follow the same index, the difference in returns between them will depend on how much fee they are charging you.

The TER is the total amount of fees that is removed from the fund each year to pay for management of the fund. This includes paying for the employees and advertisement for instance.  The TER is expressed as a percentage. This percentage is removed from the fund around the year.

When you invest passively, the only control you have over the future returns is the total amount of fees you are going to pay. You really need to choose an index fund with a very low TER.

For instance, we can look at two index funds following the S&P 500 index:

  • Vanguard S&P500 ETF (VOO): The TER is 0.04%
  • SPDR S&P 500 ETF (SPY): The TER is 0.09%

If you have 100’000 USD invested and choose VOO over SPY, you will “save” 50 USD per year. This may not sound like much. But after 20 years at 8% yearly returns, this is more than 4000 USD that you will have saved. Based only on the TER, you should choose VOO over SPY.

In my opinion, the TER is the most important metric for comparing two different index funds. However, this is not the only metric! You need to consider many other things as well.

Assets under Management (AUM)

Multiple towers of coins of different sizes
Multiple towers of coins of different sizes

There are many index funds tracking the same index. Some of them are managing a lot of money and some of them are much smaller. The amount of money one fund manages is called the Assets Under Management (AUM). This metrics gives you how much money people invested in the fund. It is an important metric to see if a fund is popular. However, it is a bit more difficult to evaluate than the TER.

Generally, a very large fund is a better choice over a very small one. If the fund is very small, there is a risk it may end up being closed. It may also indicate that it is not popular for some other reasons. A very large fund is also probably more liquid than a smaller one.

Now, there is an exception here. If you want to track the performance of an index with small-cap companies, you may want to choose a smaller fund. The reason is that if a fund is too big, the large investments in small companies may have a strong effect on its stock price. Moreover, some small-cap funds have been known to start investing in medium-cap companies when they grew. This means you are not investing in the same thing anymore.

In any case, you should not really consider absolute values. For instance, I do not think a fund managing 400 million dollars is necessarily better than a fund managing 350 million dollars. However, there is something to be said when you compare a fund managing two billion dollars and one managing ten million dollars.

Now, there is a slight twist here. For many funds, you will find two numbers. For instance, if you look at VOO on Vanguard, you will find these two numbers:

  • Fund total net assets: 400.7 billion USD
  • Share class total net assets: 90.6 billion USD

The reason is that this fund, like many others, is available as several different share classes (ETF, Admiral shares and Investor Shares). Therefore, the first number is the amount of all the shares of the stock. And the second number is the amount of all assets under management only for shares of the ETF itself.

Let’s take an example again with the Russel 3000 Index:

  • iShares Russell 3000 ETF (IWV): 9.6 billion USD AUM
  • Vanguard Russell 3000 ETF (VTHR): 420 million USD AUM

IWV is more than twenty times larger than VTHR. Based on only the AUM, you are better off with the IWV.

Number of stocks

Even though you may think that two index funds following the same index should have the same number of stocks, it is not always true. An important thing to consider when comparing two index funds is the number of stocks (or holdings) of both funds.

At the time of this writing, Vanguard S&P500 ETF (VOO) has 509 stocks. It is quite counter-intuitive since it follows an index of 500 companies! It gets even worse because the S&P500 index has in fact 505 stocks. The reason is that some companies, such as Alphabet (Google), have several classes of shares and the index comprises them all.

There are several reasons that may make an index have more, or less, stocks than its index. For instance, if the fund is too small and there are many stocks in the index, it may not yet have the opportunity to buy the smallest companies. Since most funds are market-capitalization weighted, there are more shares of the big companies than of the small ones. The fund will acquire the shares of the smallest companies as it grows. Another reason is that to save money on transactions, funds do not buy and sell all the time. Therefore, there may be some differences between the index and the fund. Finally, the managers of the fund are free to add or remove companies from the index.

Generally, you should prefer funds that have a number of holdings as close as possible to the number of stocks in the index. For most indexes, there will not be much difference between funds. But if you are looking at very large indexes, you may want to pay attention to that.

Trading Volume

Another thing is interesting to consider is the trading volume of each index fund you are comparing. This is the number of transactions that are done for the fund. Each time one share is sold or bought, the volume is increased by one. It is a pretty simple notion. Generally, a bigger fund has a bigger trading volume. However, some similar funds have much higher volumes than others.

It is important because it tells you how liquid a fund is. A large trading volume indicates that shares are easy to buy and sell for this fund. But, it also tells you that the difference between the ask price and the bid price is small. This difference is often called the bid-ask spread. The smaller the spread is, the better prices you will get when you buy and sell.

If you hold for long-term, it is not that important. But it could be good to know that you can liquidate your shares at the best price.

For instance, we can look at the average trading for three S&P 500 funds:

  • SPDR S&P 500 ETF (SPY): This fund has a trading volume of 122 millions of shares per day.
  • iShares Core S&P 500 ETF (IVV): This fund only has 6.3 million trades average daily trading volume.
  • Vanguard S&P 500 ETF (VOO): This last fund only has 4.4 million trades per day on average.

It is interesting that even though SPY is less than three times larger than VOO, it has thirty times more trading volume. It is very consistently one of the highest trading volume instrument on the stock market.

Dividend Distribution

When you hold an index fund, you hold shares from a lot of companies. Some of these companies will pay a dividend. The managers of the funds are receiving these dividends. However, in the end, the dividends are for you. Therefore, at some point, the shareholders of the fund, you, will receive these accumulated dividends.

There are two ways to do that. The fund can be actually distributing the money as a dividend from the fund. Generally, funds do that on a quarterly basis. The other way is to accumulate the dividends directly into the funds. That way the fund share price will grow of the same amount of dividends you would have gotten per share. Interestingly, European funds providers use this a lot but U.S. fund providers only use it very rarely.

In some countries, there are some tax advantages to having accumulating funds. This is not the case in Switzerland. Another advantage of accumulating funds is that you can save a bit on transactions because you do not have to buy shares with the dividends. If you plan to always reinvest the dividends, an accumulating fund may make sense. On the other hand, distributing funds may give you some more flexibility. You will have some extra cash that you can invest in whichever fund you want. You could use that to rebalance your portfolio. This is the main reason why I prefer distributing funds.

Replication Technique

I have already talked at length about index replication in the past. There are two main ways of replicating the index: Full Replication or sampling.

Full Replication means that the fund will hold shares from all the companies from the index. This is a simple strategy to replicate correctly the performance of the index. However, this is not always possible. If the index has too many companies, it may not be efficient to hold shares of all the companies.

When it is not possible, or not efficient, to do Full Replication, index funds are using Sampling. In that case, they own only a part of the shares of the companies of the index. For instance, they could hold shares of 90% of the companies of the index. This is not bad in essence and is very close to what we discussed in the “Number of Stocks” section. However, there is something different in that funds can also hold other things. Sampling funds can also hold some derivatives such as futures, contracts, and options to replicate the performance of the market. Basically, the fund managers have more freedom to do what they want.

Personally, I much prefer a Full Replication fund rather than a Sampling fund. However, if the index is really large, you may not have the choice. In that case, it is better to prefer Sampling funds with the highest number of equities from the index. That way, you will know better what the fund holds!

Currency Hedging

England Currency Notes
England Currency Notes

The last thing I want to mention is currency hedging. But first, you need to consider that not all funds are in the same currency. Generally, each fund is in the currency of the country the fund is from. Most S&P 500 funds are in USD for instance. However, if you take an S&P 500 fund provided by a European fund provider, it could be in EUR. In any case, the underlying currency would always be in dollars. It is just traded in a different currency.

Let’s get back to currency hedging now. Owning a fund in foreign currency implies a currency risk. If your base currency becomes stronger, your investments in foreign currencies will be worth less. And if they become weaker, you will get more. This is called currency risk. In the short-term, there can be a lot of variations. Some people do not want to take that risk. Therefore, they buy a fund hedged against their own currency. If you buy a USD-denominated fund hedged to CHF, it will not matter if the USD or the CHF becomes stronger. Currency-hedged funds have always more fees than the equivalent unhedged fund. This is a premium you pay to eliminate the currency risk.

There is something very important to know. It is not because you have an S&P 500 fund denominated in CHF that you do not have any currency risk. If the dollars go up or down, the value in CHF will vary a lot! As said before, the underlying currency of the S&P 500 is always the dollar. And all the companies in this index trade in dollars!

Personally, I do not invest in currency-hedged funds. I am investing for the long-term. As such, I do not believe the fees are worth it. If you invest consistently, the variations in the foreign currencies will also be averaged over time.

Conclusion

As you can see, even after you selected an index, it remains a difficult task to pick a mutual fund or an Exchange Traded Funds (ETFs) for this index. There are many parameters that you can take into account when you compare two funds.

You do not have to use all these parameters. Depending on the situation, you may only need to look at a few of them. Although it is a very important parameter, the TER is not the only thing you should look for in a fund. Sometimes, the cheapest fund is not the best. It may be too small or holding too many derivatives. And even if you do not need these parameters to make your choice, I think it is important to know them for the funds you are invested in. It is important to understand your investments!

What about you? How do you choose between two funds?

4 thoughts on “How to choose an index fund such as an ETF”

  1. Since you are explaining basics here and I am just a beginner investor, let me ask you a very simple question. Where can I find the list of all ETFs? Probably, the obvious answer is in the Internet. Indeed, I found 2 websites which I believed will provide me the same list of ETFs: http://www.etf.com and http://www.justetf.com. However, when I started looking at them, I got completely lost.

    Let’s take the same example as you used: Vanguard S&P500 ETF
    On the etf.com I could find it easily: https://www.etf.com/VOO. Indeed, TER is 0,04%, as you mentioned. Fund domicile is ??? – I don’t see this information on the webpage, probably US. ISIN is ??? (If we could see ISIN on this web page, then we could figure out the domicile from the first two letters)
    However, if we go to justetf.com, we will not find this ETF. Instead, I found Vanguard S&P 500 UCITS ETF: https://www.justetf.com/ch-en/etf-profile.html?isin=IE00B3XXRP09. TER is 0,07%. Fund domicile is Ireland. ETF Ticker is ??? What does mean UCITS? Is it an attribute saying that this ETF can be traded in European stock exchanges?

    It seems that those 2 ETFs are different funds of the same issuer Vanguard. I don’t understand “domicile” of ETF, and why there are two funds from Vanguard tracking the same index S&P 500 but it looks like domicile is important characteristic when choosing an ETF and it is worth mentioning in your article.

    I we look at iShares Core S&P 500 ETF, this is even more confusing because there are 3 such funds.
    Here is the link: https://www.etf.com/IVV. TER is 0,04%. ETF Ticker is IVV.
    On the other hand, justetf.com give us the following:
    iShares Core S&P 500 UCITS ETF (Acc): https://www.justetf.com/ch-en/etf-profile.html?isin=IE00B5BMR087 TER is 0.07%, Fund domicile: Ireland, Distribution policy: Accumulating
    iShares Core S&P 500 UCITS ETF USD (Dist): https://www.justetf.com/ch-en/etf-profile.html?isin=IE0031442068 TER is 0.07%, Fund domicile: Ireland, Distribution policy: Distributing.

    1. Hi Aleksei,

      Finding the entire list of all ETFs is quite difficult.

      • justetf.com is great but it will only show you ETFs based on your location. You can change it on the top left corner.
      • etf.com is also great but it will only show you U.S. ETFs

      VOO is domiciled in the U.S. And they do not use ISIN in the U.S.
      Vanguard S&P 500 UCITS is another ETF from Vanguard Europe following the same index. As you saw, it has slightly higher TER.
      UCITS represent funds regulated by the European Union.

      Vanguard offers funds in several countries. So they have both a S&P500 ETF in the U.S. and a S&P500 in the European Union. The regulations are different.

      The problem with ishares is the same, they also have iShares US and iShares Europe. As for the distributing policy, this should be straightforward ;)

      You’re right, I should have talked more about the fund domicile. I will do that in the next revision of the post!

      I hope that helps and thanks for stopping by!

      1. Thank you for the explanation.

        Indeed, you are right. ETF selection on the http://www.justetf.com are adapted to the country shown on the top left corner. The database of the site only contains European domiciled ETFs (no US domiciled ETFs are available). It explains why I cannot find VOO or IVV.

        “VOO is domiciled in the U.S. And they do not use ISIN in the U.S.” In fact, I managed to find ISIN for VOO here: https://www.trackinsight.com/fund/US9229083632. It is US9229083632. (As expected, it begins with the letters ‘US’.) The only think remains unclear is why etf.com does not provide this information.

        As for UCITS, you are also right. ETFs that have UCITS in their name conform to European Union regulations designed to protect the general public from unsuitable investment vehicles. UCITS stands for Undertakings for the Collective Investment of Transferable Securities. More info here: https://www.justetf.com/uk/news/etf/legal-structure-of-etfs-ucits.html

        Thank you.

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