ETF: Six questions to answer before buying an ETF

Kristia van HeerdenETF Blog, Latest

A strong investment strategy is a critical part of any attempt at successful investing. When you have a record of why you chose a certain type of investment, you are better equipped to handle the inevitable curveballs the market will throw at you.

Without an investment strategy, you might be tempted to jump ship at the first sign of trouble, resulting in too much costly churn in your portfolio. When the landscape changes and you don’t have your investment strategy on hand, you might stay in an investment too long, risking your capital.

For ETF investors, choosing an index-tracking product is already part of the investment strategy. Presumably you invest in these products because of the built-in diversification, the ease of transacting, the low cost and the assurance that your performance will reflect that of the index you bought, minus fees.

Write down the answer to the following questions before choosing your next ETF. The list is designed to help you interrogate your choices, eliminate the temptation to buy an ETF simply because it’s new and identify when your reasons for entry have changed. Keep your answers on hand and re-read them before making any decisions about your portfolio.

What asset class does this ETF give me exposure to?

Your choice of asset class depends largely on your investment time horizon. Those with more time to invest can afford to wait out big market movements and hopefully cash in on higher returns. Those approaching the end of their investment period should pull back on the risky assets and opt instead of easy growth and regular income. Asset class choices are listed in order of volatility below.

  • Equity
  • Property
  • Bonds
  • Cash

Does this ETF track a particular sector?

Choosing a sector-based ETF eliminates some of the built-in diversification that comes with an all-market ETF. While sector-based investing can offer some outperformance for those who time it right, trying to time the market can be a gamble.

Below is a list of sector-based ETFs available on the JSE:

Where in the world does this ETF earn money?

The regional question can be tough to answer. For example, while the Top 40 index tracks companies listed locally, the companies aren’t required to earn their income locally. Furthermore, developed market earnings tend to be less volatile, but also less exciting than emerging market earnings. Your choices around regional exposure depend a lot on your appetite for risk. Typically less mature markets reward adventurous investors with higher growth, providing they can withstand the bumpy ride.

Is this a factor-based ETF?

Factor-based ETFs are fairly new to the market. They attempt to track companies whose share prices exhibit certain characteristics. If, for example, a company’s share price has increased systematically over a year, or if the company’s assets are worth more than the share price indicates, these companies are included in factor-based ETFs.

Like sectoral ETFs, factor-based ETFs move away from simply reflecting what the entire market is doing. They tend to track fewer companies and once a company no longer exhibits the characteristics of the index, it is kicked out.

It’s important to understand what these ETFs will bring to your overall portfolio. If, for example, you hold a Top 40 and a factor-based ETF, you are likely to see some replication.

NewFunds Value ETF

NewFunds Equity Momentum ETF

NewFunds Low Volatility ETF

How does this ETF affect my entire net worth?

In share investments, we tend to focus too closely on the asset we’re buying. We forget that the new ETF is part of a much larger net worth, comprised of various other assets.

  • If you already own multiple physical properties, does it make sense to add a property ETF to your portfolio?
  • If your retirement product has exposure to bonds and cash, do you need to include more in your discretionary portfolio, or do you have enough in your retirement portfolio?
  • How many of the companies in the sectoral or factor-based ETFs are already in your portfolio?
  • What is your plan for companies that get added or removed from ETFs?

Am I buying because it’s new?

We’ve had so many new ETF listings over the past two years. Every ETF not weighted by market capitalisation promised returns above market return. Sometimes it will be true for some of the ETFs, but since the overall market is made up of the companies these ETFs invest in, it will never be true of all of them at once. Even if the data you see are as uncooked as data can be, what happened in the market in the past means nothing to you (unless you can travel in time). A graph of what could have happened in the past had this product existed is meaningless. What matters is whether the investment strategy makes sense to you and how much it costs.

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