how to select the best ETFs for your portfolio

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

Invest in several hundred companies, at once, with limited fees and a starting capital of only a few tens of euros. This, in a few words, is the promise that ETFs or Exchange Traded Funds make to you.

The principle? You buy shares in a collective investment vehicle which reproduces the evolution of a reference index or a 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 replicate the performance of the CAC40, the flagship index of the Paris market. When the latter progresses 10%ETFs also called index funds or trackers that imitate this index are expected to increase by the same amount.

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

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

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

Thematic or diversified ETFs: what return?

Several explanations for this. For starters, ETFs are a great tool for diversifying your portfolio. No need to buy multiple shares. You can, with a few dozen euros, expose yourself to a sector of activity or a geographical area.

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

ETFs also owe this success to their excellent performance compared to active funds. In the latest edition of its half-yearly barometer, the asset manager Morningstar reveals that only 43% active funds outperformed their benchmark index.

In the long term, the stock pickingthat is to say the fact of choosing the stocks in which one invests, often generates less attractive returns than passive investment via ETFs, estimates Marc Tempelman, co-founder of the savings platform Cashbee.

Thematic ETFs, which provide exposure to certain sectors, such as artificial intelligence, luxury or renewable energies, have been among the best performing in recent years, Morningstar highlighted in another analysis.

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

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Trackers to choose based on costs and your budget

Another strong point of ETFs: very competitive fees. On average, ETFs have management fees of at least 4 5 times weaker than active management, indicates Mathieu Caquineau, financial analyst at Morningstar.

In detail, these costs amount to 1.35% for active funds, against 0.32% for ETFs. But behind these averages, there are sometimes significant disparities, particularly on the side of sectoral ETFs.

The pricing advantage is very clear for trackers on major indices, indicates Marc Tempelman. But the world of ETFs has exploded, with cybersecurity, mining and even cannabis ETFs that can apply fees similar to pilot management.

The final advantage of index funds: they can be accommodated in almost any envelope. This includes your securities account, your stock savings plan (PEA), as well as most life insurance contracts.

Within the framework of the PEA in theory limited only to French and European stocks, index funds even allow you to expose yourself 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 the broad sense, there are in reality several types of ETFs. The latter are distinguished mainly by the way in which they reproduce their reference index.

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Physical or synthetic ETF: what are the differences?

The easiest to understand are physical trackers. To constitute them, the issuer purchases all of the securities included in the target index. For example: if the manager wishes to replicate the CAC40, he acquires the shares of the 40 French companies that make it up, respecting their weighting in the index.

In the case of synthetic ETFs, on the other hand, the manager does not need 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. Result: a synthetic ETF replicating the American S&P500, which follows the price of the 500 largest companies listed in the United States, may prove eligible for the PEA.

Synthetic ETFs are often lower in fees than physical trackers. However, they are less popular with savers. At issue: a risk inherent in this type of index fund.

So-called synthetic ETFs carry a counterparty risk which arises if the intermediary with whom the ETF issuer has entered into a contract is no longer able to provide the performance of the index. This is the case if he goes bankrupt, for example. In practice, however, this risk is diversified and closely monitored, points out Mathieu Caquineau.

Whether you opt for a synthetic or physical ETF, there are several indicators to assess the quality of an index fund. Among these, the performance gap between the value of the tracker and its reference index, also called tracking difference.

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

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Some markets less favorable to trackers

start with the market you want to invest in. Because not everyone is necessarily suitable for passive investment. In the American equity market, ETFs are attractive because the indices are very difficult to beat in the long term, observes Mathieu Caquineau.

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

Index selection can also be complicated. For the same market, there is in fact a multitude of indices. In the United States, for example, the three main indices, the Dow Jones, the S&P500 and the Nasdaq, coexist with dozens of secondary indices.

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

Don’t stop at the name of the tracker. 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 not to be overlooked: take an interest in the company that puts the tracker. Because it is better to entrust your money to big names in the sector, recognized for their reliability, such as Lyxor, Amundi, iShares or even Ossiam.

Finally, favor ETFs with a good level of liquidity. Because a stock market vehicle, whatever it may be, presents what managers call a spread risk when it trades little. In other words, the spreads between purchase prices and sale prices are increasing.

Because the ETF is continuously traded in the market, its price may deviate from its net asset value when you buy or sell. In general, the volume of orders means that the spread is very small. But, sometimes, when the ETF is not very liquid, a significant mismatch can occur, explains Mathieu Caquineau.

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

In the event of significant and recurring discrepancies, this means that index funds may present a hidden cost on sale. This is why it is recommended to invest in index funds with a capitalization of at least 100 million euros.

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