Revealed: Interactive Investor's Rated ETFs for 2017

Exchange traded funds (ETFs) - historically seen as cheap, no-frills choices with widespread appeal - provide a useful way to access the direction of stockmarkets at low cost (for short or long periods), and to cover areas where actively managed funds struggle to deliver returns ahead of an index.

Indeed, passive funds have evolved over recent years and it is now possible to track everything from commodities to currencies and bonds.

However, many investors do not take the same care over their passive investments as they do over their active selections. There may be a narrower distribution of outcomes, but investors should be alert to them nonetheless.

Just as important is the fact that there is a variety of ways to gain exposure to regions and asset classes. In Asia, for example, investors have a choice between ETFs with a high exposure to developed markets such as Australia, Japan or Singapore, and ETFs with a higher weighting to developing countries such as China and Indonesia.

Rated ETF choices

With all of this in mind, we have narrowed down the range of more than 1,700 ETFs traded on the London Stock Exchange, to produce a shortlist of around 50 equity index-based ETFs, 16 global equity sector ETFs, 23 fixed interest ETFs and nine exchange traded commodities (ETCs) for our sister website Interactive Investor that we think investors should consider.

Even basic ETFs that replicate an index differ significantly. Cost has become the headline way for funds to differentiate themselves, and fund providers increasingly strive to shave a few decimal points from their ETFs' ongoing annual charges.

However, costs may be relatively high in some cases. The cost of buying a currency-hedged version of an ETF, for example, will be around 0.2% higher than an unhedged ETF. Equally, the cost of replicating more esoteric markets and indices will be higher.

In fact, the costs of some "smart beta" or "active" ETFs can be almost as high as those of actively managed funds.

That said, for most "plain vanilla" passive funds the costs are low, and a decimal point or so of difference probably won't have a significant impact on your investment over the long term.

Tracking error is an important consideration, as it will vary depending on how managers choose to replicate an index, rebalance the portfolio and reinvest dividends. It will also depend on the timing of reinvestment and myriad other factors.

Trackers may use physical replication (buying stocks in the same proportions as those in the index, so that performance matches that of the index) or synthetic replication (using a derivative provided by an investment bank to guarantee the index performance).

Physical replication has proved more popular with private investors, even though it will often have greater tracking error. In theory, synthetic replication introduces counterparty risk if an investment bank defaults.

But the biggest consideration for investors in the selection of a passive fund is whether it is appropriate for their investment needs - a concern that can get rather lost in the debates on fees and counterparty risk.

ETFs can be used in different ways: some investors buy passive ETFs as core holdings and build "satellite" holdings around them. Investors also often use passives to get exposure to highly researched stock markets such as the US, which has proved difficult for active managers to beat over the long term.

Fixed-interest securities, such as UK government bonds, are another area where the use of ETFs is popular. With 10-year gilt yields at relatively low levels, fees have greater impact on investments, so investing at the lowest possible cost is important.

How the Interactive Investor ETF list was selected

Screening basis

• Only the 1,700-plus exchange traded funds traded on the London Stock Exchange were considered.

Equity and fixed interest ETFs

• Only ETFs with a sterling share class were assessed. We did not include any currency-hedged ETFs in this selection.
• We referenced Morningstar's Star Ratings for ETFs, as at 10 August 2016. Only ETFs with between three and five stars were considered for the Interactive Investor shortlist.
• Within each asset group, we have endeavoured to identify the best ETFs from a range that we believe will suit customers' investing requirements. These include ETFs that focus on different market segments (such as larger or smaller companies) or that include or exclude specific countries or currency zones.
• Within each asset group, where possible, we have included a number of popular "smart beta" and "active" ETFs, such as those that employ a socially responsible or environmentally sustainable overlay, those that target sustainable dividend income, or those that seek to minimise volatility.

Exchange traded commodities

• We have endeavoured to identify ETCs which are of most interest to investors, and have favoured those with a sterling share class over others. We did not assess currency-hedged ETCs. Where an ETC focuses on precious metals we have favoured those backed by physical holdings. Please note that Morningstar does not provide Star Ratings for ETCs.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.