OPTIMIZING YOUR PORTFOLIO - How to pick the perfect EQUITY ETF
If you read about Investing from a US source you know how easy it is to invest in North America (select two Vanguard Funds – US Stocks & Local Bonds, sit back, relax and enjoy the Passive Income).
And yet in Europe and the UK, selecting an Equity ETF can be a bit of a different ballgame.
Not only is Europe more fragmented. For instance, the second-largest ETF provider in the US, Vanguard, doesn’t even cover 5% of the market in Europe. There are also aspects like currencies or dividends.
But it’s also never been easier to buy ETFs. By doing some initial research you can avoid life-long fees charged by Robo and Human Advisors.
It will make you substantially wealthier.
How to Choose an Equity ETF
Choosing an ETF involves three steps. First, decide which benchmark your portfolio needs to track. Then, choose the ETF Provider and prioritise certain Fund characteristics based on your circumstances. Finally, compare the costs and performance of the relevant Funds.
What else will you learn
Did you know that some ETFs beat their benchmarks consistently?
A number of my readers are often confused about ETF fees. Because TER is not what should be looked at.
I also frequently receive questions about ETF currency risk. Well, there are four currency types in an ETF. That’s not very intuitive. But you can ignore some of them and once you get a grasp of it, choosing the right ETF will be simple.
To illustrate the ETF Selection Methodology, we will use the Vanguard FTSE All-World (VWRL) as example.
How to choose aN EQUITY ETF in 3 Steps
STEP 1 - CHOOSING A Benchmark
Choosing an Index is the most important decision.
- An Index defines the underlying investments and their weights
- Some Indices like MSCI ACWI or FTSE All-World cover the entire World
Illustration - How much exposure will I have to different countries if I buy a World ETF?
Do you want to spread your wealth widely across all Equities or capture unique market segments?
You can invest across the entire world with one ETF or tilt your portfolio:
- Towards regions such as the Emerging Markets, or even drill down into individual countries
- Focus on specific industries, a specific equity strategy or specific investment themes
Example - Vanguard FTSE All-World
Vanguard FTSE All-World Tracks the FTSE All-World Benchmark.
The Firm that created the Index is FTSE Russell. You can find details about the underlying holdings on the Index Provider’s webpage.
Deep Dive - What no one explains properly (MSCI vs. FTSE)
International ETFs can be confusing due to naming conventions used by Index Providers.
For example, ETFs can be divided into Developed vs. Emerging or Small vs. Large Caps.
Click on the image to understand how the World is divided so that you can control the allocation to countries in your portfolio.
STEP 2 - FILTERING ETFS BY Characteristics
Once you have selected a benchmark you can drill down into fund characteristics.
You can save considerable amounts of money by optimizing taxes and reducing various ETF risks.
2.1 Choosing an ETF provider
Key European ETF providers by Assets under Management
The US big three – BlackRock’s iShares, State Street SPDR Funds and Vanguard ETFs are all present in Europe. But local players have also a strong footprint – DWS Xtrackers, Amundi or UBS.
As of 2019, total assets for European ETFs exceeded €750 bn out of which:
- BlackRock’s iShares dominates the European Market with a market share of c. 45%
- Amundi (including Lyxor) ETFs were the second largest with c. 14% Market Share
- DWS’ Xtrackers managed roughly 12% of all assets
Diversity - Key European providers by ETF Count
The combined Lyxor and Amundi ETFs together offer the most options for Europeans with over 1,000 different ETFs.
iShares offers over 500. Vanguard despite its small size in Europe is still a great option – it does offer the cheapest and most diversified Funds, but it can’t compete in specialized investing niches.
Example - Vanguard FTSE All-World
Vanguard FTSE All-World is managed by Vanguard Global Advisors.
The Firm is the second biggest ETF Asset Manager in the World. Learn more about what makes Vanguard special.
2.2 FINDING AN ETF
How to look for an ETF in Your Broker Account?
In most cases you can use the name of the Fund or its ISIN to search for the fund with your stock broker:
- FUND NAME – this is the easiest way to lookup a Fund, type the first letters and the ETF will likely show up.
- ETF SHARE CLASS – Once the fund shows up select the ETF Share Class. This is important and you will often find clues about income treatment and currency hedging in the share class name.
- ISIN – The second best way to look up a Fund. The first two letters stand for the domicile of the fund (e.g. LU0641006456 for Luxembourg). It’s convenient because ISINs for ETFs with multiple currencies will have the same ISIN. Unless the ETF is currency-hedged. ISINs will be different for an ETF that distributes and one that accumulates dividends.
Alternative ways
- TICKER – is comprised of a few characters linked to a specific exchange. The problem in Europe is that since the same Fund can trade on multiple stock exchanges it might have different tickers as well so it may not always be easy to find it that way.
- SEDOL – a unique instrument identifier allocated by the exchange
Example - Vanguard FTSE All-World
Vanguard FTSE All-World Dividend Distributing ETF trades on multiple exchanges as explained in the ETF Factsheet.
When you start typing the ticker (VWRL), your broker may show you on which exchange you can buy the ETF. Below three Stock Exchanges show up – LSE, AEB (NYSE Euronext) and EBS (SIX Swiss). As mentioned, some exchanges have different tickers. Here it’s VGWL (Deutsche Borse).
ETFs available to trade with Interactive Brokers
2.3 ETF Size and Inception Date
ETF Size Matters
Look out for the size of your specific Fund- it should be at least 100 million, ideally above €250m to reduce the risk of the fund closing e.g. due to commercial reasons
Over 100 ETFs close each year. I have personally experienced it and since it was a busy period in the office I was caught off guard at that time and I didn’t sell before it closed.
The proceeds of ETF liquidation were ultimately paid but it took a few weeks before hitting my account which is always an opportunity cost.
ETF Inception Date Matters too
Again, closure risk is part of the risk of being an active market participant and new ETFs always have more commercial risk than large, more established Funds with a long track record.
Example - Vanguard FTSE All-World
How do I determine Fund size?
The fund’s factsheet comes in handy again. Look for overall size (yellow), Share Class size (red) may be misleading. Some share classes can be tiny, that’s why it’s important to look at the overall size.
2.4 ETF Currency RISK
ETF currencies may seem confusing at first.
It may seem intuitive to look for ETFs that trade in your home currency. But this is not always the best choice. And shouldn’t be prioritised.
There are four currency types when looking at an ETF:
- The underlying assets’ currencies
- The hedging currency
- The trading currency
- The Fund base currency
However, only the first two of them are important.
Make sure you understand the underlying currencies you will be exposed to and hedge, if needed. Only then (and if available) try to buy a share class denominated in your home currency.
Example - Vanguard FTSE All-World
Let’s have a look at the fund’s factsheet.
- The underlying assets’ currencies are not explicitly listed in the Factsheet. Each underlying equity share trades in its local currency. You will be exposed to all world currencies in proportion to the weights of the companies, or more precisely to the currencies, they do business in.
- The Hedging Currency is not mentioned in the share class description (yellow part). The Fund is thus Unhedged.
- The Trading Currencies depend on the Exchange where the ETF is listed (green). Picking your currency is the best practice here.
- The Base Currency is mentioned in the share class description (yellow) and at the bottom (purple). This is largely irrelevant.
Deep Dives - Become an Expert in Currency Risk and Hedging
The Underlying currencies have a major impact on the ETF’s return. Hedging matters as well.
The last two currency types listed above have a lower impact.
Click on the image to understand why certain currency types matter more than others and how to look at them.
In most cases, you can decide to hedge the underlying assets’ currencies.
Is currency hedging beneficial? It depends on your time horizon and whether it’s Equities or Fixed Income.
Click on the image to understand why you should sometimes hedge and when you probably shouldn’t.
2.5 Replication Methodology
- Physical (full replication) – This method is employed if the underlying assets are readily available, reasonably small in number and do not significantly alter (e.g. 100 shares in the FTSE 100). ETF will hold positions in all companies.
- Physical (sampling) – ETF holds positions in a relevant subset of the companies detailed in the index. The subset is chosen so that the performance of the fund matches the performance of the index as closely as possible. This approach might be used if the benchmark contains a large number of assets that change frequently (e.g. the MSCI World Index with more than 1,600 constituents).
- Synthetic – ETF uses financial derivatives to replicate the performance of the index to investors. Be aware that these ETFs do not hold the underlying positions directly but track nevertheless their performance.
Full replication vs. Sampling
Example - Vanguard FTSE All-World
The fund’s documentation states that the asset manager is using physical optimized sampling as a replication method.
Deep Dive - Understand How to Select Safe Synthetic ETFs
Synthetic ETFs may not be suitable for investors that are just starting out.
Unless you consider getting explicit benefits from your US exposure, there is no reason to make your portfolio complicated and potentially riskier. But there are exceptions.
Click on the image to understand why you should sometimes consider synthetic ETFs.
2.6 Fund Domicile
- You know where an ETF is domiciled by looking at the first two letters of its ISIN e.g. LU0641006456 for Luxembourg.
- In Europe, most ETFs are domiciled in Ireland or Luxemburg, for various tax breaks reasons.
- Irish-domiciled ETFs benefit from the US/Ireland double taxation treaty, which reduces standard withholding tax rates on US stock dividends from 30 to 15 per cent and – may prove beneficial if your ETF invests in US Assets.
- If you buy a Worldwide exposure US will represent the largest allocation.
- There are exceptions to these rules. If you are a Dutch Investor, the US has a tax treatment with the Netherlands that completely avoids any withholding tax leakage. It may be worth investigating buying an ETF domiciled in the Netherlands.
Example - Vanguard FTSE All-World
The fund’s documentation states that the Fund is domiciled in Ireland. As such, it benefits from lower withholding taxes on US companies’ dividends.
Deep Dive - Easy (and Boring) Money or How to Reduce Taxes
Irish ETFs may seem like a no-brainer. But additional considerations can play a role. For example, the ETF domicile choice only impacts Equity ETFs and not Bond ETFs since there are no withholding taxes on US Bonds.
US ETFs can also be very tax efficient.
Click on the image to understand why you should sometimes consider US ETFs.
2.7 Dividend Distribution Policy
- Distributing Shares Classes will pay dividends and generate regular income from your portfolio that you can spend if you need to. You can also use dividends as part of your rebalancing process.
- Reinvesting (Accumulating) Share Classes will maximize your future returns as they automatically reinvest your income back into the market with no extra fees (saves your time and reduces transaction fees).
- Both options i.e. accumulating and distributing (aka dividend-paying) may not always be available. In this case it’s good to remain flexible.
- Depending on your country of residence the choice may have tax consequences.
- In some jurisdictions, accumulating share classes are a way to avoid dividend taxes while in others accumulating funds and distributing are taxed the largely the same way (e.g. the UK or Switzerland) regardless of physical dividend payment (it’s deemed to have been paid for tax purposes unless it’s in a tax-wrapped vehicle like ISA or SIPP in the UK)
Example - Vanguard FTSE All-World
The ETF share class we analyzed so far (VWRL) was a distributing share class. The above factsheet shows the other available (accumulating) share class.
Deep Dive - Understand Dividend Tax and Convenience Trade-offs
Choosing a distributing vs. accumulating Share Class comes down to determining (i) whether you are still saving for retirement (ii) your country dividend tax treatment (iii) broker transaction costs (iv) and convenience.
We have designed a decision tree for that.
Click on the image to understand how to reduce taxes on dividends.
STEP 3 - COMPARING ETF PERFORMANCE
Now that you have filtered for a number of candidates, performance is a good final step to select the best ETF.
But remember, the above steps are more important. Tracking Difference doesn’t always guarantee future outperformance.
3.1 What is the true cost of an ETF?
One of the main advantages of passive investing is low costs.
However, there are certain misconceptions about the true cost of an ETF which is not the TER or OCF.
Breakdown of ETF Provider-related Costs
The TER (Total Expense Ratio) or OCF (On-going Charge Figure) is only the visible part of the total (ETF Provider related) cost and includes trading costs and management expenses.
This visible cost part has been undergoing significant compression. In fact, some of the ETFs in the US are sold at no cost.
On-going Costs
Average On-going Fees for Equity Funds
Equity ETF Fees have been on a downward trend over the past decade but vary depending on the complexity of the ETF and the underlying Market (e.g. Emerging Markets still require a fee premium compared to Developed Markets)
But what exactly is the less visible part and how can I track it?
- The less visible part of Tracking Difference has two components: costs and revenues. It has not been formally agreed with the European Union, hence it’s not standardized.
- Some ETFs can be more tax-efficient than their rivals or the benchmarks. Usually benchmarks holding US Stocks are also penalized in this comparison as their performance assumes a full Withholding tax of 30% vs. for example 15% for Irish ETFs.
- Other visible costs that may not be directly shown include Rebalancing or Swap Costs (for Synthetic ETFs).
- ETFs can have side hustles, too. And side hustles can make a lot of money! The less visible part also includes some additional revenues that may increase the ETF’s performance due to e.g. Security Lending.
Example - Vanguard FTSE All-World
The Vanguard FTSE All-World ETF has a net cost (Tracking Difference) of 0.02%.
That’s much lower than the stated On-going cost (TER) in the Fund’s documentation of 0.22%.
But in this case TER is a good ballpark, since it holds US Stocks. Some of the apparent ‘savings’ come from an inflated tax rate on US dividends in the benchmark return.
That’s roughly 15 bps (or 0.15%) of penalty for the index (2% dividend rate x 15% tax difference x c.50% US holdings in the ETF).
The true cost of holding VWRL vs. its benchmark is thus c. 0.17%.
3.2 How to compare ETF performance
These invisible parts can make all the difference.
Apparently expensive ETFs (high TERs) can in fact yield the highest net returns.
This is driven by ‘negative costs’ (aka revenues) that determine the best Funds (using TD as measure).
When comparing funds, make sure:
- Funds you are comparing have the same underlying benchmark
- Funds have the same hedged currency
- The length of the analysis is at least one year (longer is better)
In red, ETFs outperformance vs. benchmark after taking into account TER, tax efficiencies and other revenues.
As you can see similar TERs don't necessairly translate into same performance.
Illustration - Use TE to compare Funds & how Funds can outperform benchmarks
Deep Dive - When to look beyond Tracking Difference
TER and TD both have their drawbacks but are probably all you need to assess ETFs.
Tracking Difference is the most acccurate metric to compare two ETFs but there are exceptions since it may ignore certain recent events.
Click on the image to understand when you need to look beyond Tracking Difference.
Conclusion
There is probably a lot of new material here if you are just starting out.
Take the time to digest it.
The most important decisions you will ever take in respect to your Financial Independence Portfolio relate to Asset Allocation, selection of the best Equity Benchmarks or proportion of Bonds in your Portfolio.
Don’t rush it, do your research first and ask questions (below) if needed.
Good Luck and keep’em* rolling !
(* Wheels & Dividends)
DISCLAIMER
All information found here, including any ideas, opinions, views, predictions expressed or implied herein, are for informational, entertainment or educational purposes only and do not constitute financial advice. Consider the appropriateness of the information having regard to your objectives, financial situation and needs, and seek professional advice where appropriate. Read our full terms and conditions.
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Hi Raph,
Got the email for this one quite promptly, great read as always. Thanks for the mention, clarification and introduction to trackinsight!
Would be a great tool to utilize in my hunt for the perfect ETF (for me at least)!
Thanks.
Thanks, Jack. Let me know if something else doesn’t make sense.
Hi Raph, So, I went away and did some digging, and I got another (silly) question. As my broker profits’ off of spreads rather than a platform fee, would your advice be to go for a distributing ETF with a high volume and low spread (~5p which is ~0.06%) or an accumulating ETF with a slightly lower volume and higher spread (~11p which is ~0.10%). The ETFs intend to track the same index (VWRL and VWRP are two such examples) and all other variables seem to be the same. My intention is to re-invest dividends anyways, and the ETF will… Read more »
Hi Jack – No such thing as silly questions here – all comments are welcome if I can help. It also comes down to the other asset classes you have in your portfolio and the type of re-balancing because you can use dividends for that purpose as well. Don’t forget to take into account the frequency and amount of contributions you will make over time. I would probably do a quick spreadsheet simulation to figure out what may be beneficial in the long run. Good choice on the ETFs BTW 🙂 I just did a deep dive into World ETFs… Read more »
Nice read! Now you gonna get some traffic from Poland 🙂
It seems to be getting some traction there, indeed 🙂
This is so cool!
Thanks, James
Hands down the best guide for Europeans! Congrats
Thanks, Miklos. Glad you get benefit from it!
Finally a decent non-US investment blog! Great work!
Thanks Tom!
Hi Raph –
Great how-to for ETF selection
All the best,
Nico
Thanks Nico!
Hi Raph,
VEUD TRACKING DIFFERENCE +0.21%, TRACKING ERROR +0.09%
VDEM TRACKING DIFFERENCE -0.18%, TRACKING ERROR +0.25%
How to correctly understand TRACKING DIFFERENCE if one ETF + 0.21% and another -0.18%
Which is a better result?
Hi CureBear –
I just posted a quick summary to answer your question
Hope it helps,
Raph
Hi,
Thank you for this information,
Now everything is clearer. 🙂 But I found an article about tracking difference.
Have you done similar research due to inaccurate information?
https://fairvalue-magazin.de/etf-indexfonds/etf-vergleich/tracking-difference/
Hi CuteBear –
Can you please elaborate on the inaccuracy in the article so that I can help?
Raph
Great article. A few questions and a proposal 🙂
Hi Ambush –
(i) Best way to get this data is to check the ETF provider’s, in this case, iShares website – have a look at the Allocation section and you will get the Underlying Currency Breakdown
(ii) Correct, but it depends on how the provider calculates it. Usually these will be Total Returns (includes a combination of price change and paid dividends). For accumulating funds your reasoning is correct
(iii) I will revert on this question in due course.
Raph
Regarding your last question this may help
thanks for this great investment resource! I especially like the European viewpoint. I don’t know if you’ve already written about this, but I couldn’t find any information about WHERE to buy world ETFs. For example the recommended vanguard VWRP sells in many (3+) European stock exchanges. Where do I buy it from? What are the considerations except for the currency exchange? Are automatically deducted taxes in Germany more than in UK? If you haven’t blogged about this already it seems to me it’s a good idea for a future article 🙂
thanks again
Hi Nikos –
Please see a comment here that answers you question
Raph
Hello, That’s my first comment, thus, forgive me if you have already addressed such questions. Based on your great arcticles, I’m building my first ETF portfolio ever (70% Equity, 30% Bonds) to start saving for my retirement (only 34 years left…). I’m wondering what’s your thought/suggestions on such ETFs: – IE00BGV5VR99 – IE00B1XNHC34 – IE00BYWQWR46 – IE00BYXG2H39 – IE00BFYN8Y92 Unfortunately, I’m European / Polish which narrow the number of available ETFs that I’m able to buy for retirement plan. PS: Love that we share the same passion which for me is ca. 70% road / 30% Enduro3 PS2: A Happy… Read more »
Hi Bart –
I haven’t written any deep dives on thematic ETFs but remember that you will need to stick to those throughout the cycle and consider valuations. Something that I touched upon when talking about ARK Funds.
Cheers,
Raph
Hi Raph, Thank you for your hard work! Amazing blog, really. I have just got a question about the ETF domiciliation. Say I am from Poland and I bought iShares Core MSCI World UCITS ETF on XETRA. This ETF is Ireland domiciled, will I have tax obligation in Ireland or only in Poland, as my sole tax residency is in Poland? Poland and Ireland have a double taxation agreement and in Poland I would pay only capital gain tax. Am I missing anyting? Are there any other aspects that one should take into consideration when buying ETF domiciled in Lux… Read more »
Thanks, Erik.
I aim to provide more clarity on taxes but the short answer is you personally won’t have to pay anything in Ireland. If the ETF is domiciled in Ireland the fund does not withhold dividend taxes for e.g. Polish investors.
The fund will pay a withholding tax e.g. 15% for US dividends, though.
Hi Erik – I have written a separate guide related to withholding taxes.
Hope this helps.
Sooo many words — while it would be perfectly fine to replace with “safe bet is SWDA or VWCE for 5+ years of investment; or even V80A/V60A if you never want to look at it until retirement”. You’re welcome 😉
Hi Jozef – If you’re going for a 1-ETF Portfolio I have a dedicated section for hands-off Investors including as you mentioned Vanguard LifeStrategy pre-packaged portfolios. This guide is specifically designed with tailored portfolios in mind and people that want a bit more control over their portfolio including as you’ve seen (i) choosing the composition of your portfolio, (ii) fee reduction or (iii) tax optimisation. With respect to your suggestion, a VWCE/SWDA ETF may not be suitable for a 5-year horizon, as explained here in more detail. No such thing as ‘Safe bet’ in Investing 🙂 but most importantly in… Read more »
This is a great resource! Would you consider doing a similar guide on how purchasing UCITS ETFs from different venues (e.g. LSE, IBIS, BVME) impacts capital gains tax withholdings, depending on the fiscal residency of the investor (e.g. person in France buying an ETF on the Milano exhange vs. buying the same ETF on XETRA)? I know there are probably too many variables to consider, but it would be great if you could summarize somehow. For example, there are a few ETFs I´m interested in, which are only traded on the London Stock Exchange and because of Brexit, there is… Read more »
Thanks for the feedback. The short answer is yes – I plan to release more guides including how to buy an ETF and the choice of exchange.
With respect to withholding taxes there are already resources available.
FYI – I have a newsletter in case you don’t want to miss it when it’s released.
Very complete! Well done mate, that’s a good intro for this subject.
Thank you James.