Important ETF Metrics You Must Know

Disclaimer: The content below is for educational and informational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. Investing involves risks, including potential loss of capital. Past performance is not indicative of future results. Investors should consult a qualified financial advisor or conduct their own research before making investment decisions.

Investing in Exchange-traded Funds (ETFs) is generally considered cost-efficient and relatively liquid, but choosing the right one among thousands of options can get overwhelming. It's the one decision that really matters, as it affects everything from cost to return. ETF metrics are helpful here as they allow you to choose the right ETF for you. However, ETFs carry market risks, and metrics do not guarantee performance or protect against losses.

While there are many ways to evaluate ETF performance, ETF metrics help you assess the market quality of an ETF. In this blog, we will understand how to evaluate ETFs and the different metrics you must know.

What Are ETF Metrics?

ETF metrics are tools that allow you to know how an ETF is constructed and how it functions in real market conditions. These metrics describe the market quality of the ETF, rather than the appeal of the market it is invested in. In its essence, ETF metrics can be used to respond to three practical questions:

What is the long-term cost-efficiency of the ETF?
To what extent does it follow the index it is supposed to follow?
How easy is it to purchase and sell without friction?

Important: ETF metrics describe past or current performance characteristics and do not predict future results.

The ETF performance metrics are the fundamentals of how to analyse ETFs. They are concerned with form, effectiveness, and performance. What ETF metrics fail to do is equally important. They do not forecast future returns and cushion you against market fluctuations.

Key ETF Metrics You Must Know How to Track and Analyse

Here are the top ETF metrics you must know as an investor and trader:

1. ETF Expense Ratio

The ETF expense ratio is the amount of money that an ETF charges annually to cover the cost of management and operation. Consider it the cost of maintaining the fund in operation. It is automatically charged against the assets of the fund.

Minor variations in expense ratios can accumulate over time. A 0.2% or 0.3% difference might seem negligible in one year, but over ten years, it can significantly reduce your returns. Long-term performance may be affected by this cost.

The lower cost ratio does not necessarily make an ETF the superior option. It does not indicate the accuracy with which the ETF tracks its index or its ease of trade. That is, cost is not the only part of the puzzle.

2. ETF Tracking Error

ETF tracking error is used to determine the level at which an ETF tracks the performance of the target index. Consider the index as a trail and the ETF as a hiker attempting to walk the trail. An ideal hiker will follow the trail precisely, whereas a tracking error will indicate where the ETF is going off-track, whether it is slightly ahead or slightly behind, or making minor detours on the path. Tracking error occurs due to a number of practical reasons:

Costs: Fees and expenses reduce returns slightly than the index.
Cash drag: ETFs keep a certain amount of cash as liquidity, which may result in small gaps.
Rebalancing: The ETF can change the holdings less often than the index.
Market friction: Slippage and timing differences in the purchase or sale of assets.

Reduced tracking error is usually desirable. This is why you must seek uniformity, not the occasional exceptions. You must also look at the long-term trends and not the short-term noise. Even a low-cost, well-tracking ETF may still be frustrating to use when it is difficult to trade.

3. ETF Liquidity

ETF liquidity is the ease with which you can buy or sell the shares of an ETF without influencing the price. It is not the popularity of the ETF or the number of people discussing it, but the ease of trading. Liquidity has two aspects:

Liquidity of the ETF itself: The level of activity of the ETF on the exchange.
Liquidity of underlying assets: The ease with which the ETF can sell or purchase the stocks or bonds it owns. Even a thinly traded ETF can be an efficient trader as long as its underlying assets are liquid.

Here is how ETF liquidity influences your trading experience in the real world:

Bid-ask spreads: Broader spreads imply that it is more expensive to enter or leave.
Execution price: The lack of liquidity may cause price movements.

4. Fund Size

Fund size is the amount of assets that an ETF has. Larger ETFs tend to have more capital invested in them, and this may make the trading easier and less risky in that the ETF may close down at any time. With a larger fund, there are usually advantages:

Improved liquidity: Generally, the more assets, the smaller the bid-ask spreads.
Stability in operations: Large funds have fewer chances of closing down because of low demand.
Cost efficiency: Economies of scale may maintain competitive ratios of expenses.

5. Key Information Document (KID)

A Key Information Document (KID) is a brief, standardised document that describes the important characteristics of an ETF. It is created to provide investors with a clear picture without having to read long prospectuses. The KID will assist you in checking:

What does the ETF invest in?
Its expenses, such as the ETF expense ratio.
The risk level and potential returns.
Previous performance (not a forecast, as background).

Consider the KID as a roadmap, as it provides the fundamentals you require in the evaluation of ETFs. It is a handy metric to compare ETFs against each other before going into details of such metrics as tracking error, liquidity, and fund size. KIDs are required under EU regulations and aim to enhance transparency for investors.

Other ETF Performance Metrics and Factors to Consider

Besides the abovementioned metrics, here are the other ETF performance metrics and factors you must consider when investing in the ETFs:

1. Multiple Exchange Listings

There are numerous ETFs that are traded in various currencies on numerous exchanges. Select ETFs in your own currency where feasible to avoid the needless conversion expenses. When investing in a foreign-currency ETF, you have the choice of whether to have the currency exposure or a hedged version.

2. Underlying Assets

You must know what your ETF is actually investing in, particularly with sector or thematic ETFs, where composition may differ significantly across similar-looking funds. Review the top holdings and sector allocations. A sector ETF may be concentrated on a small number of large companies or diversified among many smaller companies, which may have an impact on performance and risk.

How to Evaluate ETFs with These Metrics

There is no single measure that narrates the whole story. ETF analysis is most effective when measures are considered in combination, since each of them displays a different aspect of the way the ETF operates in reality.

Tracking error + expense ratio: Low costs matter, but not unless the ETF also tracks its index closely. A combination of these measures demonstrates the effectiveness of the ETF in fulfilling its promises.
Tracking error + liquidity: An ETF may perform well on paper, but when it is difficult to trade, even minor deviations can be expensive. By looking at both, you can be sure that you can buy and sell without any problems.
Liquidity + expense ratio: An affordable ETF can disappoint an investor if it is not liquid. Combining price and trading convenience will assist you in selecting ETFs that will be comfortable to hold in the long term.

When analysing ETFs, you can easily lose track of the numbers. An ETF that you understand is usually better than trying to analyse everything. Correlate the metrics to your intended use of the ETF. Do you have long-term or trade often? Depending on your approach, the metrics that are important vary. Metrics cannot eliminate risk or guarantee returns.

Conclusion

Two ETFs may track the same index, but have very different experiences. At first sight, they may appear the same. Same index, similar name, similar chart. However, when you invest, the difference is reflected in the cost, accuracy of tracking, and ease with which you can buy or sell.

ETF performance indicators are practical instruments for making smarter decisions. They provide you with an understanding of the way an ETF operates, allowing you to compare alternatives and identify possible problems prior to investing. Investors must understand that these metrics do not predict future performance or protect against losses.

Disclaimer: This content is for educational purposes only and does not constitute investment advice, personal recommendations, or a solicitation to buy or sell financial instruments. All investments involve risk, including potential loss of capital. Investors should consult professional financial advisors and consider their personal circumstances before making any investment decision.