What makes a good equity ETF?

12 Oct 2022

Market commentary

Commentary by David Hsu, senior equity index and ETF product specialist, Vanguard Europe.

ETFs are a key part of Vanguard’s mission to give investors the best chance of investment success.
ETFs offer low-cost, liquid access to diversified global indices.
With thousands of equity ETFs on offer, look under the bonnet to make sure your product gives the exposure you expect.

No matter what kind of exposure investors are seeking, exchange-traded funds (ETFs) can offer low-cost, liquid access to diversified indices, with full and regularly updated transparency on constituents, performance and costs. These qualities have made them arguably the most dynamic new investment product coming to the market in the last two decades.

Letting you cast your net wider

For an asset class as deep and diverse as equities, ETFs can offer investors far greater exposure than they would otherwise be able to achieve on their own. For example, someone investing in the Vanguard FTSE All-World UCITS ETF would gain coverage of over 4,000 large- and medium-sized companies spread across 50 countries, spanning both developed and emerging markets.

But what makes a good equity ETF? In a universe where there are 1,993 European ETFs¹ available to investors, the nuance of process and variety of coverage is almost infinite. The choice can be overwhelming.

Look under the hood

The first question you should ask is whether an equity ETF is actually giving you the tight index-tracking exposure you think it is. Replicating a market as compact as the FTSE 100 is more straightforward, but what if you are looking at a globally diverse index? The cost of reproducing it on a stock-by-stock basis would be prohibitive. Here, the key is how efficiently your ETF aligns itself with its ever-evolving index.

Cost is the other critical variable. An ETF that can’t efficiently manage and respond to the constant daily index changes will inevitably be more expensive, which in the long run could markedly erode returns and defeat the objective of investing in an ETF in the first place. Effectively navigating such changes and maintaining minimal tracking error in an ETF requires timely but considered corresponding trades.

Expertise, experience and scale

Vanguard has developed its expertise on how to deliver value to investors in these areas over decades as we were the first to bring ETF investing to the mass market in the US in 2001.

We devote significant resources to investing in and supporting our portfolio managers and the trading process. Our global platform uses the most up-to-date technology and tools in an effort to keep up with evolving markets. Our size also facilitates economies of scale through high trading volumes, allowing us to drive down broker costs and keep overall charges low.

On-the-ground relationships count

Being global is arguably as important in managing ETFs as it is in active funds. With desks in the US, UK and Australia, we can leverage both global and local broker relationships to enhance our trading execution and to lower costs for our investors. In addition to broker relationships, we maintain our engagement with local regulators, exchanges and industry groups to bring about positive market structure-related changes in our respective regions.

Another aspect of Vanguard is that our portfolio managers are also traders for our ETFs. The trading and portfolio management functions are integrated into one team, which is especially important when we manage and trade upcoming index rebalances, corporate actions and daily cash flows. We seek to minimise tracking error to the benchmark while at the same time limiting the fund’s transaction costs.

The value to be gained by trading ETFs efficiently should also not be overlooked. By choosing Vanguard, you will have access to the insight of our ETF Capital Markets Team, who can help you achieve the best possible execution experience when trading our funds.

Never forget the basics

A good equity ETF has to be of a sufficiently large size in terms of assets under management—usually around $10 million—to help ensure sufficient liquidity and tight spreads. It is also advisable to check trading volumes as those which trade infrequently could be less easy to sell. Finally, keep a firm eye on tracking error. If your ETF deviates too far from your chosen index then it is not performing its advertised role, thereby potentially delivering unexpected results and unbalancing your portfolio.

¹Source: ETFGI as at 31 July 2022.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

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Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments.

For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com.

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