Part 2 - Which products do I want?

Choice overload

This post is part of an 8-post series on the construction of my portfolio.

In part one I set my target allocation: 75% stocks (tilted toward Dividend & Value), 10% bonds, 10% cash equivalents, 5% gold.

To turn my asset allocation into a working income stream, I need to select and buy financial products. I am going with Exchange Traded Funds (ETFs). They offer the liquidity, diversification, and the low cost needed to manage a portfolio efficiently without the risks of individual stocks or paying too much for mutual funds.

Unfortunately, the ETF market has exploded. There are now thousands of products available to European retail investors. How do you choose? As a first filter, I use four well-known product selection criteria, plus a fifth that is more personal.

During the migration to my target retirement portfolio these criteria act as guidelines. So what are they?

ETF selection criteria

1. Large fund size

I look for large, established ETFs. As a rule of thumb, I prefer funds with at least €500 million in Assets Under Management (AUM), and over €1 billion for core building blocks (large positions). Reasons:

• Large ETFs trade with higher volumes on the exchanges; they are more liquid. This means the bid-ask spread - the difference between the buying and selling price - is usually narrower. Since I will be selling portions of my portfolio periodically to fund an income stream, higher trading costs would act as a drag on my returns.
• Managing an ETF costs money. If a fund fails to attract sufficient assets, it becomes unprofitable or difficult to trade. The asset manager will eventually close it or merge it into another fund. Something I would like to avoid because of the uncertainties involved.

Liquidity is maybe a bit abstract, but imagine this.

You try to sell a position and the order cannot be executed right away. You wait, check, wait some more, check again. Check the bid-ask. Limit looks good, but you lower it a bit to be sure. Check hours later. Still nothing. You do that again. Nothing. Finally, hours later the order goes through. Happened to me a couple of times and I find it unnerving.

2. Low TER but mind the TD

Every basis point (1% is 100bps) matters. When I rely on taking out a 4% income stream, I would rather not lose 50bps or more every year to fund managers. I aim for a low Total Expense Ratio (TER), targeting 0.20% or lower for global equities and competitive rates for more specialised assets.

Be aware that not all costs of an ETF are in the TER. Bid-ask spread, transaction & rebalancing costs, dividend leakage, broker fees are examples of costs that might not be directly visible in the TER. ETFatlas offers a good list of different types of costs.

And some of these are internal costs, some external. That is an important distinction. justETF has an excellent article with a more detailed explanation.

Now, Tracking Difference (TD) is an objective, hard metric of how the ETF performs with respect to the benchmark. This takes into account all internal costs to the ETF. It is a more complete measure than the TER.

For example. You have an ETF and check its performance against the index. The index went up 10%, and your ETF went up 9.8%. Your tracking difference is -0.20% or -20bps. You instantly know that factors like fees, transaction costs, and portfolio management reduced your total return by 0.20 percentage points compared to the index.

Also make sure to check actual returns. Of course, a must when comparing products that do not follow the same index.

3. Physical replication

Non-negotiable for me: the ETF must use physical replication, meaning it actually holds the underlying shares or bonds - real Microsoft or ASML stock for an MSCI World fund, not a promise of it.

Synthetic ETFs use swaps with a bank instead. That can mean a lower tracking difference, but it adds counterparty risk: if the bank runs into trouble, so can my ETF.

In retirement, I’d rather give up a fractional gain than take on that structural risk. Real, tangible securities it is.

4. Leading asset managers & well-known indices

I choose leading, trustworthy global asset managers - BlackRock (iShares), State Street (SPDR), Vanguard, DWS (Xtrackers) and UBS - as a basis. These firms have the scale to survive market turbulence, possess top-tier trading desks, have enough scale to keep the cost down and make me sleep well at night.

Furthermore, ETFs must track well-known, transparent benchmarks from established index providers like MSCI, FTSE, STOXX, or Bloomberg. A well-known index means a documented, predictable methodology. It guarantees that the index rules are publicly audited and stable, preventing the fund manager from shifting the goalposts on what qualifies as a “value stock” or a “short-term bond”.

My fifth factor

Beyond the technical setup of the ETF itself, I add a fifth condition that is more personal: How much information does the asset manager actively offer about the product? Because I like to play with the data and do some research myself, I look for providers that offer downloadable daily holdings disclosure with extra information. Historic returns are also very convenient. As is other information.

For example. Take one of my gold ETCs offered by Invesco. A crucial element of this ETC is that real, physical gold bars are stored in a vault. Right on the product page, I can easily find and download reports from an independent auditor verifying that those bars are actually there. I understand that not everyone wants to read audit reports, but for someone with trust issues, it’s very reassuring.

Guidelines for selection

To see how these criteria will shape our product search, we have to overlay the three major conditions established in part 1: maintaining a minimum 40% EUR currency allocation, an underweight position on the US and overweight Asia + Emerging Markets.

The table below illustrates how the product requirements match up against my strategic targets:

Table: Target allocation and selection criteria

The table shows some tension between my macro-level rules (40% EUR allocation, underweight US, overweight EM) and my product-level requirements (low TER, physical replication, well-known indices).

What is next?

With these rules in hand, the next step is to run the screening process, compare the shortlists, and select the ETFs that will build my portfolio. Part 3 covers this for stocks.