Exchange Traded Funds (ETFs) are often portrayed as investments for ‘beginner’ investors. Some of them track well known indexes or ‘easy’ to understand themes. They are straightforward to trade. They are more approachable than picking individual shares.

However, all investors should be cautious before choosing an ETF. There is a big difference from buying an investment and finding the best investment for you.

Choosing an ETF requires thoughtful analysis about whether it is the right investment to help you reach your goals over the long-term. Many ETFs are slickly marketed and play on the appeal of a popular theme. A healthy scepticism about the financial services industry and the products they roll-out is helpful.

When I was looking for an international equity ETF, I went through a structured process to find the right investment for me. My process involved the following steps:

1. Review my goals and investment strategy
2. Assess the ETF mandate based on my criteria
3. Review how the mandate is implemented
4. Review the rules governing changes to the ETF holdings

This example illustrates the considerations you can take to pick an ETF that fits your needs.

Understand your goals and investment strategy

Many investors immediately jump to choosing investments and forget about the process of investing. Investing is the process of defining what you want to accomplish and finding investments that fit your criteria. Before logging into your broker, clearly define your investment objectives. We’ve written extensively on this before. Start with understanding the asset class exposure that you need given the rate of return you need to achieve to get to your financial goals.

The financial goal that I am finding international equity exposure for is a long-term goal. I don’t need to access it for at least the next decade and am not focused on deriving any income from the portfolio in the meantime. It will sit in a portfolio that is tilted heavily to aggressive assets. I am looking for broad international equity exposure for a holding period of 10+ years.

Once you’ve gone through this process, you will have a clear understanding of what you want to achieve. Understanding your objective makes it easier to identify the criteria to find ETFs for your portfolio.

Assess the mandate against your criteria

Each ETF has an investment mandate that outlines its objectives, approach and any guidelines on what the ETF can or can’t invest in. The mandate is one of the best ways to determine if a specific ETF aligns with the objective that you want to achieve. Finding an ‘international’ ETF is very broad. However, I can narrow down the list with further criteria from my investment strategy:

A long holding period

What matters is the returns achieved after taxes and fees. I want to keep taxes and fees as low as possible as this will make a significant difference over a long holding period. I try to find low-cost vehicles with low turnover which increases tax efficiency. I am happy to exchange a bit of volatility for long-term returns. Long holding periods reduce the risk I will make poor timing decisions on the purchase and sale of ETFs.

International equity exposure

International equity exposure is a broad category. I need to narrow down the global investable universe. Options include narrowing it down to the developed world or a few specific countries. I could divide global shares into small, mid or large cap companies. I could pick an active or passive approach. There are 176 international equity ETFs listed in Australia (at 8 January 2025). My focus is on broad exposure to shares which eliminates narrow mandates such as thematic ETFs or sector specific ETFs.

I’ve decided to exclude thematic/sector specific ETFs for a few reasons. It assumes:

• That I’ve picked the right theme or narrow part of a broader market
• Stocks that fit that theme aren’t already fully valued
• I’ve picked the right fund provider to execute investment in this theme.

You can conduct this exercise for each part of your portfolio. Deciding on an active or passive strategy is the first decision I am faced with.

Morningstar conducts a bi-annual research report called the Active Passive Barometer. It outlines where active managers have typically underperformed. Although past performance is not an indicator of future performance, it gives valuable insights into the types of markets where an active manager may be able to add value, and where passive investments may fear better.

Overall, the general trend of the report is that passive investments tend to outperform active over the long-term in most sectors and markets as they are not handicapped with large fee hurdles that they must beat first to outperform their benchmark. The latest report shows that just over half of all active funds outperformed their passive peers (June 2024).

However, there are areas where active managers are able to add value. They are sectors and asset classes that may not be well-covered by analysts and the broader market, where they are able to find opportunities. Examples of this include real estate funds and bond funds.

The report is free to access and can help make an informed decision about whether to choose an active or passive investment.

I don’t believe the track record for active managers is strong enough to justify choosing an active fund.

Review how the mandate is implemented

Most developed markets require fund managers to display their entire holdings list. That is not the case in Australia. In Australia, most fund managers only reveal their top 10 holdings or delay the release of their holdings data by 90 days. This is in an effort to protect their Intellectual Property (IP). In reality, it just makes it difficult for investors to understand what they’re investing in. More transparency would be helpful. Lucky for us, ETFs must disclose their holdings (more on the differences between ETFs and managed funds here). This makes it much easier to find an ETF that matches your criteria.

Understanding the exposure helps you assess how the ETF fits into your portfolio and whether it complements your existing investments. Look for overlap with existing holdings.

When I search for passive ETFs that have broad exposure to international equities, there are several options to choose from.

International passive ETFs

 

Source: Morningstar Investor, comparison of passive International equity ETFs

Review the rules governing changes to the ETF holdings

There are several influencers of the after-tax, after-fee returns of an ETF. If you are struggling to choose between similar ETFs this may be the tie-breaker.

Portfolio turnover: Turnover refers to how often the underlying holdings in a fund or ETF are rotated. ETFs with low turnover have higher tax efficiency which may lead to better after-tax returns. Turnover is caused by rebalancing or if there are periodic re-running of security selection criteria. If the fund mandate stipulates that the portfolio must be rebalanced frequently, it will influence the portfolio turnover rate and the tax that is owed which eats into your returns. The portfolio turnover rate for IWLD is 4.92% (last available), VGS is 1.38% (last available) and BGBL is not available.

Volatility and long-term objectives: As this is a long-term investment, volatility is not a key consideration. However, if you are drawing down on an investment, or have a shorter time horizon, beta (volatility) might be an important consideration.

Fees: Fees are a big one. There are several fees that are attached to an ETF. I’ve written about the total cost of owning an ETF here. High fees are a drag on returns, and this should be the determining factor on identical ETFs from different providers that are tracking the same index.

For international equities, hedged or unhedged: International equity ETFs have two main components of return – the return of the underlying investment and changes in exchange rate. Hedged investments remove the currency component of the return, resulting in just getting the investment return. There are several factors that influence the relative performance of currencies. Global geopolitical situation, relative levels of interest rates and inflation are some of the factors that may influence currencies. To correctly make a directional bet on currency is hard. Given the tax and transaction costs of switching between hedged and un-hedged products means I want to stick with my choice over the long-term.

The considerations for picking one or the other are based on your personal circumstances. Mark and I go through which ones may suit differing circumstances in this Investing Compass episode.

Look past the marketing material

ETF providers are trying to sell you a product. Look beyond the surface level descriptions of an ETF to understand how it works.

For actively managed ETFs, examine the manager’s track record. Do they have a history of acting in the investors’ best interest? Is there high turnover within the management team that results in constantly switching portfolio managers?

It is difficult to predict the future decisions of a fund manager. However, having a look at the past track record and how they have approached governing and running their funds can provide some idea. Mark has written about a few examples of poor investor outcomes in his article here, which runs through choosing an income ETF. He speaks particularly about the decision for Blackrock to change the mandate of IWLD and the implications for investors.

Final thoughts

Choosing an ETF requires balancing your investment goals and the specifics of the fund. They are not custom investments and will never be tailored perfectly for your purposes. The aim of the game is to find the closest match. You can do this by matching the ETF’s mandate, analysing its exposure and how it operates, and cutting through marketing noise. Carefully considering each set of criteria may mean better long-term outcomes and peace of mind.

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