How to pick an ETF and a tracker fund

An investment journey should start by defining your investment goals, time frame and attitude to risk. That applies to any type of investment, whether it is ETFs, tracker funds, bonds or even individual stocks.

Once you’ve established those points, you can think about where you would like to invest.

Someone new to investing starts with a blank sheet of paper, whereas an existing investor needs to decide if they want to buy more of what they’ve already got or venture into a different part of the investment world.

How can I tell what an ETF or tracker follows?

ETFs and tracker funds are designed to mirror performance of an index, which is a basket of assets that meet certain criteria.

For example, a S&P 500 ETF is a passive fund that tracks the performance of the S&P 500 index – a basket of 500 companies listed on an American stock exchange. Inclusion in this index is based on various factors including a company’s size and profitability.

If the S&P 500 index goes up by 10% in a year, an S&P 500 ETF should do the same minus the annual charge built into the fund.
The underlying index is typically featured in the ETF or tracker fund name. If it’s not, you can discover the relevant index by looking at a fund’s fact sheet.

What are my investment choices?

You can find ETFs or tracker funds that follow broad indices containing stocks from around the world, or ones specific to a single geography. You can also get exposure to certain industries or to specific investment styles such as companies that pay generous dividends.

You’re not restricted to stocks and shares – ETFs and tracker funds will also provide exposure to bonds, property and commodities including gold.
Once you’ve made your decision, the next step is to filter the market and narrow down your choices.

How to create a shortlist

You can choose from thousands of ETFs and tracker funds. While that sounds a lot, there is a way to avoid feeling overwhelmed.

AJ Bell has free research tools that help you to pinpoint specific types of investments, including a handy ETF search system.

This tool lets you specify certain criteria, such as geography and sector, so you aren’t searching aimlessly across the entire investment universe. You can also search by charges, dividend yield, fund size and a lot more.

Let’s run through the example of finding an ETF that provides exposure to the US. Using the AJ Bell search tool, under ‘Geographical region’, tick the box that says ‘United States’ and instantly the investment universe is more than halved.

The field is narrowed further if you also look at the cheapest funds, which in the case of the search tool are ones that cost less than 0.5% a year.

Let’s say you only want to invest in the biggest funds with exposure to the US. Clicking the ‘£1bn+’ box under ‘Fund Size’ will reduce the pool to just over 350 names. The list is cut to 205 funds if you then select ‘Accumulation’ under the ‘Income or Growth’ field. This focuses on funds that automatically reinvest any dividends.

Lastly, you have the option to select the Morningstar rating tab which rates funds on performance and costs. If you choose the five-star rating alongside the other selection already discussed, this quick and simple tool has narrowed the universe down to around 50 funds for further research.

To start a new search simply clear all the choices in the selected tabs.

A similar process applies to tracker funds if that’s what you’re looking for. Go to the fund search tool and select ‘Passive’ under the ‘Management Style’ box to focus on tracker funds.

How many ETFs should I hold?

One of the key benefits of ETFs and tracker funds is the broad diversification they provide, which reduces the risk of concentration and holding too few stocks or bonds.

Many people ask, “What is the optimal number of ETFs to hold?” There isn’t a one-size-fits-all answer, as always it depends on individual goals and risk appetite.

At one end of the spectrum an investor might be happy to hold a single global equity ETF and a single global bond ETF. However, that might seem quite limiting for more adventurous investors.

Instead, it might be useful to think in terms of a ‘core and satellite’ approach with global stocks and bonds forming the core and doing the heavy lifting, complemented by specialist investments around the edges.

One risk to consider is unwittingly creating a concentrated portfolio by investing in too many products which overlap in terms of holdings. That’s why it is important to look closely at what’s inside an index.

A quick way to look under the bonnet of your portfolio is to use the Morningstar Portfolio X-Ray tool, which is free for AJ Bell customers. Just log into your account and click the X-Ray icon.