How To Choose An Index ETF

5 minute read

If you found the Index Funds section in Stocks, Mutual Funds, ETFs, And Indexes interesting, we’re about to go a little deeper into these bad boys.

By the end of this post you will have a pretty solid understanding about where to research ETFs, how to judge them, and how to pick them to suit your particular investment goals.

Index ETF providers

Ever since Jack Bogle founded Vanguard and invented indexing in 1975 & 1976 – a time when a can of coke cost a few cents – many companies followed suit. Today, index ETFs are created and managed by several companies called ETF providers, the biggest of which include:

  • Vanguard
  • BlackRock
  • State Street Global Advisors
  • Deutsche Bank
  • Invesco

Index ETF domicile

Just like you and I are born in a country, ETFs are also born in a country. An ETF born in the good ol’ US of A is said to be domiciled in the US. One born in Ireland is said to be domiciled in Ireland.

The domicile of an ETF dictates which stock exchange it is bought & sold on. However, that’s not all it determines.

ETFs, like companies, pay dividends. The dividends they pay investors are taxed. An ETF’s domicile dictates the rate at which dividends from the ETF are taxed.

Lastly, domicile also determines what happens to an investor’s ETF holdings after he or she dies while holding them.

We’ll cover the implications of domicile on taxes in a minute.

Expense ratios of the most popular index ETFs

We’ve already talked about the Management Expense Ratio (MER) of an ETF. Why is it that index ETFs have some of the lowest MERs you can find?

Well, the main reason is that these funds are passively managed. They don’t hire over-paid financial professionals to make trading decisions. What does this mean for your as an index ETF investor? More of your money is invested in the fund, and less of it goes towards paying for fund manager salaries.

Low MERs is one of the biggest reasons we love index ETFs so much.

So what does a reasonable MER look like for the popular index ETFs out there?

As of today:

  • VTI: 0.03% per year.
  • SPY: 0.09% per year.
  • VT: 0.09% per year.
  • QQQ: 0.2% per year.
  • IWM: 0.19% per year.

The list can go on forever. As you can see, reasonable MERs range between 0.03% – 0.2%. Why such a big range? Different ETFs have different sizes (amount of money invested in them by investors like us). The smaller an ETF the larger it’s fee needs to be to cover admin expenses. International ETFs also need to hire admin employees internationally, which typically makes international ETFs more expensive.

Anything above 0.2% and you would need to start asking questions like: Why is the ETF so expensive? Is it being actively managed by professionals? Are these professionals actually going to beat the market to justify these absurd expenses? Hint: Probably not.

Estate taxes

When you die, any ETFs you owned are passed onto your beneficiaries.

When this happens, the U.S. government withholds an “estate tax” on the portion of your ETFs that exceed a certain limit. This limit is $60,000 as of today.

ETFs domiciled in Ireland have a much higher limit before estate tax kicks in. As of today, the Ireland limit is somewhere around $400,000.

So, if you have children or you plan to die soon (awkward pause), you will need to start considering the estate tax implications of your ETF choices; Try to weigh your portfolio more heavily towards Ireland domiciled ETFs.

Planning to retire off your dividends soon? Why not move some US-domiciled ETFs to Ireland-domiciled counterparts? You’ll pay half as much in taxes on the dividends.

Dividend taxes

Benjamin Franklin once said:

In this world nothing can be said to be certain, except death and taxes.

As with most stocks & mutual funds, ETFs pay dividends, which are taxed by governments. U.S. domiciled funds have a dividend tax rate of 30% — even if you are not an American citizen. Ireland domiciled funds have a lower rate of 15%.

So, if you are not an American citizen, and are from a country that doesn’t have a special tax treaty with the US, you are usually better off owning the Ireland domiciled ETFs where possible. This will reduce the aggressive estate taxes and dividend taxes you have to pay.

If you are an American citizen,  you will need to look at your particular tax situation to see which flavor of ETF to invest in, US or Ireland. As cliche as it sounds, I’d recommend finding a good tax advisor to help with this.

How to pick an index ETF

A lot of the work behind ETF picking has already been done for you by various sites and blogs. That said, always do your own due diligence.

Below are a few sites you can use to research ETFs and do apples to apples comparisons between them:

You can use these resources to understand the MER of an ETF, the historic performance of an ETF, and analyze what an ETF invests in.

Things you should be watching out for are:

Diversification:

Is the index ETF you are investing in diverse enough? Does it contain enough companies such that the failure of one doesn’t have a dramatic impact on the overall ETF? For stock index ETFs, we suggest only picking those with 300+ stocks in them.

MER:

Is the cost of investing in this ETF competitive enough with similar ETFs in the same ETF category? If not, find a cheaper ETF that basically does the same thing. Hint: Vanguard’s ETFs usually have the lowest in the market, which explains their popularity.

Domicile:

Where is the index ETF domiciled, and how will this impact your dividend and estate taxes? Try to go for Ireland domiciled funds where possible.

Correlation:

Does the index ETF you are buying actually behave similarly to the underlying index it is supposed to track? To verify this, you could compare a graph of the actual index with a graph of the ETF. If they overlap closely over time, you’re good to go.

Summary

  • There are many ETF providers out there.
  • Index ETF expense ratios range between 0.03-0.2% – the lower the better.
  • An ETF’s domicile is an important factor influencing in which ETF you invest.
  • Tax rates on ETF dividends vary between 15-30% – don’t be surprised when you see these on your statements.
  • Reduce the impact of estate taxes after you die by picking Ireland domiciled ETFs instead if their US domiciled cousins.
  • To pick an ETF, make sure it is diversified, low-cost, and correlated to the index in which you are investing.
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