The stock market: how to choose the best ETF for your portfolio

Individuals are massively investing in ETFs and new investment vehicles are emerging every day. Why such success? And how to choose the best funds for your portfolio?

Invest in several hundred companies at once, with limited fees and initial capital of only a few tens of euros. This, in a nutshell, is the promise ETFs or exchange-traded funds give you.

Principle? You buy shares in a collective investment vehicle that reproduces the performance of a benchmark index or basket of shares. These shares can then be bought or sold on the stock exchange at any time. Just like stocks.

For example, there are ETFs that track the performance of the CAC40, the flagship index of the Paris market. When the last advances 10%ETFs, also called index funds or trackers, that mimic this index are expected to rise by the same amount.

ETFs are nothing new, strictly speaking. The first of these funds was established in 1993 in the United States of America. However, in recent years their popularity among individual investors has exploded, especially in France.

In the second quarter of 2023, there are almost 131,000 people who carried out ETF transactions, against 103,000 people in the same period in 2021, according to the Office for Financial Markets (AMF). Or an increase 27.2% more than 2 years.

Result? Capital invested in ETFs worldwide exceeded $7.86 trillion, according to Black Rock fund manager estimates. Or almost 5 times more than 10 years ago. And the increase is expected to continue in the coming years.

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Thematic or diversified ETF: what return?

A few explanations for this. For starters, ETFs are a great tool for diversifying your portfolio. No need to buy more shares. With a few tens of euros, you can expose yourself to a sector of activity or a geographical area.

For example: MSCI World is an international stock index that aggregates shares of companies in 23 developed countries. With ETFs that track this index, you can invest 1513 companies which compose it. And that in a single transaction.

ETFs also owe this success to their superior performance compared to active funds. In the latest edition of its semi-annual barometer, asset manager Morningstar reveals just that 43% active funds outperformed their benchmark index.

In the long run, it is stock selectionThis means that picking the stocks one invests in often generates less attractive returns than passive investing through ETFs, estimates Marc Tempelman, co-founder of the savings platform Cashbee.

Thematic ETFs that provide exposure to certain sectors, such as artificial intelligence, luxury or renewable energy, have been among the best performers in recent years, Morningstar pointed out in another analysis.

However, these higher return prospects come with additional risk. Thematic funds limit the scope of investments and are therefore synonymous with increased volatility, warns Marc Tempelman.

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Trackers you can choose based on cost and your budget

Another ETF strength: very competitive fees. On average, ETFs have minimal management fees 4 5x weaker than active management, suggests Mathieu Caquineau, financial analyst at Morningstar.

In detail, these costs amount to 1.35% for active funds, against 0.32% for ETFs. However, there is sometimes significant variation behind these averages, particularly on the sector ETF side.

The price advantage for trackers on major indexes is very clear, suggests Marc Tempelman. But the world of ETFs has exploded, with cybersecurity, mining and even cannabis ETFs able to charge pilot-like fees.

A final advantage of index funds: they can be placed in almost any envelope. This includes your securities account, your equity savings plan (PEA) and most life insurance policies.

Within the PEA, theoretically limited to only French and European stocks, index funds even allow you to gain exposure to foreign stock markets, whether American or Asian.

This eligibility is possible thanks to so-called synthetic ETFs. Because although we often talk about trackers in a broad sense, there are actually several types of ETFs. They are characterized above all by the way in which they reproduce their reference index.

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Physical or synthetic ETFs: what are the differences?

Physical trackers are the easiest to understand. In order to create them, the issuer buys all the securities included in the target index. For example: if the manager wishes to replicate the CAC40, he will acquire the shares of the 40 French companies that make it up, respecting their weight in the index.

In the case of synthetic ETFs, on the other hand, the manager does not have to own the underlying securities. Instead, it contracts with a counterparty, usually an investment bank.

The latter is then responsible for providing the manager with the same performance as the target index. The result: a synthetic ETF replicating the US S&P500, which tracks the price of the 500 largest companies listed in the United States, may prove eligible for PEA.

Synthetic ETFs often have lower fees than physical trackers. However, they are less popular with savers. The problem: risk is inherent in this type of index fund.

So-called synthetic ETFs carry counterparty risk, which arises if the intermediary contracted by the ETF issuer is no longer able to deliver the performance of the index. This is in case he goes bankrupt, for example. In practice, however, this risk is diversified and carefully monitored, points out Mathieu Caquineau.

Whether you choose a synthetic or a physical ETF, there are several indicators for judging the quality of an index fund. Among them is the difference in performance between the tracker value and its reference index, also called tracking difference.

Simply put, the higher the tracking difference, the less the ETF is close to its benchmark index, which is not a good sign, Marc Tempelman summarizes. But other factors are also taken into account when choosing an ETF.

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Some markets are less favorable for trackers

start with the market you want to invest in. Because not everyone is necessarily suitable for passive investing. In the US stock market, ETFs are attractive because indices are very difficult to beat over the long term, notes Mathieu Caquineau.

On the other hand, active managers outperform in some markets. This is especially the case in emerging markets, which are characterized by a very broad investment universe, more volatile currencies and different macroeconomic cycles, the analyst continues.

Choosing an index can also be complicated. There are actually a large number of indices for the same market. For example, in the United States, the three major indexes, the Dow Jones, the S&P500, and the Nasdaq, coexist with dozens of secondary indexes.

However, these different indices often produce different performances. Between 2018 and 2021 performance Lyxor DJ Global Titans 50 exceeds e.g +67%against +37% for Lyxor MSCI World UCITS ETF Monthly Hedged. Or the income gap 23% between these trackers, both of which are part of the global stock category.

Don’t stop at the tracker’s name. Take the time to read the key information document to understand the fund’s strategy, applicable fees as well as the level of risk, advises Marc Tempelman.

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Tracker liquidity

Another point that cannot be overlooked: take an interest in the company that will place the tracker. Because it is better to entrust your money to big names in the industry, recognized for their reliability, such as Lyxor, Amundi, iShares or even Ossiam.

Finally, prefer ETFs with a good level of liquidity. Because the stock market, whatever it is, presents what managers call spread risk when there is little trading. In other words, the spreads between the bid and ask prices are widening.

Since the ETF is constantly traded in the market, its price may differ from the net asset value when bought or sold. Generally, order volume means that the spread is very small. But sometimes when an ETF is not very liquid, there can be a significant mismatch, explains Mathieu Caquineau.

This represents a hidden cost for the investor. However, it is possible to protect against this liquidity risk. The saver can look in particular at the volume of orders placed and the difference between historical purchase and sale prices, the analyst continues.

In the case of significant and recurring irregularities, this means that index funds may present hidden costs when sold. Therefore, it is recommended to invest in index funds with minimum capitalization 100 million euros.

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Total:

To get started with ETFs and make the right decisions for your portfolio:

  • Select the market you are interested in (sector of activity, geographic area, etc.) and select the index that best matches that range.
  • Ask yourself the investment vehicle you want to place your ETF in (securities account, PEA or life insurance) and make sure the fund is eligible.
  • Compare management fees of different ETFs, as well as brokerage fees, and open an account with the most competitive provider.
  • Make sure the ETF is sufficiently liquid and capitalized, then check the reputation of the issuing company.
  • assess ETF quality using financial indicators such as tracking reference or tracking error.

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