How to choose the best ETF for you

Exchange traded funds are still in demand at a time when markets are choppy and difficult to predict, but investors are being selective, preferring broad-based, diversified index-tracking products.

Around 1.9 million Australians are investing in ETFs, up 6% from the year before. ETFs listed on the ASX attracted $13.5 billion of inflows in 2022, but asset declines caused by falling share and bond markets meant the ETF market size dropped by 2.7%. Globally, a massive $1.24 trillion poured into ETFs.

In contrast, unlisted actively managed funds in Australia had one of their worst years in 2022 as investors took out $26.6 billion.

Active ETFs were also unpopular with Australian investors. The typically higher investment management fees charged by active ETFs ate into returns and the manager's claimed ability to beat markets by handpicking securities often failed to materialise

By choosing broad-based index ETFs, investors get the benefit of low fees, less tax liabilities than a managed fund, a broadly diversified portfolio in one security, lower risk and trading flexibility.

"Several factors, such as oil prices, inflation, interest rates and central bank policy, geopolitical tensions and protectionism are currently influencing markets," says Chris Brycki, founder and CEO of Stockspot, an online, robo advice group that builds portfolios for investors using ETFs.

Brycki points out that nobody knows how these factors will pan out for markets into the future.

"It's all the more reason to own a diversified portfolio that can perform in different economic regimes and stick with an automated strategy for rebalancing," he says.

"It pays to remind yourself of the bigger picture when markets are down. While corrections can be stressful, our advice to clients has always been to stick to your diversified strategy, stay invested and perhaps top up if you have the cash reserves."

Brycki says research shows that fewer and fewer active funds can outperform simple index funds consistently over time.

While the Australian ETF market reached $133 billion at the end of 2022, spread among 319 funds, it still has a long way to go to reach the US. ETFs make up about 4% of the total funds market in Australia compared with around 25% in the US.

The Australian equities ETF category had the highest inflows, with $4.4 billion last year, not quite as strong as the $5.5 billion in 2021.

With crashing markets, defensive sectors did well as investors, particularly retirees, capitalised on higher yields from bonds. Fixed income was in demand, attracting the second largest inflows with $3.6 billion, up from $2.9 billion in 2021.

With global markets in disarray, investors placed around a third of what they had invested the year before, with $3.3 billion in international ETFs.

Yet despite investors selling active ETFs, providers launched 17 new active funds last year, making up a third of the 52 new ETFs listed on the ASX, a record number of launches.

"This trend is particularly striking given the large number of active ETF launches, with the actual flow activity seemingly not dissuading managers from launching active ETF classes of their unlisted funds," says Ilan Israelstam, chief commercial officer at BetaShares.

The range and number of ETFs is making choosing the most appropriate product challenging for some investors. You can now buy ETFs that are multi-sector funds for peppercorn fees. Or lots of exotica, such as thematic funds that invest in artificial intelligence and robotics or cybersecurity or healthcare biotechnology. You can also buy into numerous global ETFs that invest in a wide variety of countries, sectors and regions.

The worst performer in 2022 was the BetaShares Crypto Innovators ETF. It might have appeared a winner when it was launched at the end of 2021, and it briefly rose 11%, but by the end of 2022 it had lost 82%. Other poor performers had large exposures to technology companies.

The two most popular ETFs are broad-based Vanguard funds.

The Australian Share Index ETF, known by its sharemarket ticker VAS, attracted $11 billion last year. It tracks the shares in the S&P/ASX 300 for a flat fee of 0.10%. Second was the MSCI Index International Shares ETF (VGS), which tracks the MSCI World ex-Australia Index (with net dividends reinvested and hedged to the  Australian dollar) for a fee of 0.18%. Investors put more than $4 billion in the ETF.

Vanguard also offers four diversified ETFs that have pre-mixed asset classes such as local and international shares as well as fixed income, small companies and emerging markets. The funds suit different long-term risk and reward factors, including conservative, balanced, growth and high growth.

How to select the right ETF for you

• Check long-term performance 
Focus on picking ETFs with a track record over multiple years, not the short term.

• Monitor the liquidity. 
Look at the daily volume traded and how liquid the underlying holdings are. Larger and more liquid markets generally have a lower bid/ask spread, meaning lower transactional costs.

• Analyse the investments.
What are the underlying holdings, exposure and allocation? Most ETFs track an underlying index, so check the index methodology to understand how the holdings, exposure and allocation are chosen.

• Factor in fees.
What are the costs of the ETF? How do these compare? Typically, expensive ETFs often relate to active fund managers or complex underlying strategies that include leverage, synthetic instruments and inverse products. These come with higher risks.

• Be sceptical of the marketing. 
ETF issuers market new products heavily, so investors need to analyse the timeframe and whether fees or tax are included, and how the new product compares with existing products.

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