How to pick a strong performing ETF

How to pick a strong performing ETF

27/05/2019 - Sam Green

With the explosive growth of exchange traded funds or ETFs over the past few years, plenty of investors are wondering which ETFs to pick for their portfolios. In today’s article, we look at some of the best performing ASX-listed ETFs over the past 12-months, as well as the volatility of their price movements.

Keep in mind that past performance is no guarantee of future performance, and that diversifying across ETFs with exposures to different asset classes and geographical regions is also a very important part of ETF portfolio construction.

We can see above that many ETFs have achieved significant returns over the past 12-months. Usually some of the biggest returns can be seen in smaller funds, or funds with low market capitalisation. However, over the past 12-months, many large-scale ETFs have also enjoyed strong performance. The well performing funds saw on overrepresentation of the Australian property and Australian resources sectors, buoyed by strong performance from ASX listed companies in these industries.

It is not uncommon to see some funds enjoy very strong performance followed by extremely weak performance, such is the nature of volatility, that is why we also look at the volatility of returns to try and determine if the levels of returns provided by a fund are worth the risk. Below are those same ETFs, sorted by lowest 12-month price volatility to the highest.

You will notice that the best performing portfolios aren’t necessarily the portfolios with the lowest price volatility. Deciding between high performance and low volatility is a difficult decision and there is no right or wrong answer. Rather, portfolio managers will target a volatility level, and try to construct a portfolio of assets that achieves that volatility target, with the highest levels of expected performance. To do this, they will often plot different assets across performance and volatility, and then formulate a line of best fit through the plot – assets that sit a large distance above this line are thereafter considered the best picks.

Once you get to this point, you can get the formula for the line of best fit and calculate the exact distance of each ETF from the line – in order to pick the funds that are the greatest distance above the line. However, once you have done this, you also have to ensure that you are picking ETFs that are in different sectors and regions; a good way of doing this is to calculate the correlation of price movements between the different ETFs you are looking at, which will give you a ratio known as a “beta” – you then want to try and get the sum of all betas of the portfolio as close to zero as possible – which is an attempt at ensuring that there is complete diversification across the assets of the portfolio.

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