We use "tracking funds" as building blocks of portfolios. To select these funds, whether they are ETFs or Unit Trusts, we look at a wide range of uncompromising criteria:
Credibility and reputation of fund managers
Underlying market size of assets larger than half a billion USD;
Funds at this size are liquid and highly tradeable because there is a lot of market participation in the funds. In the case that the fund itself isn't as sizable, we consider the liquidity of the market it tracks.
Although index-tracking funds, such as ETFs, can be very inexpensive vehicles, we put an emphasis on quality when selecting which ones to put in your portfolios. We know that good funds do not have to be expensive to be effective, but we also know that the least expensive funds aren't always the most effective.
The tracking fund needs to provide straightforward exposure to underlying asset class, no leverage, and no inverse payoffs;
The tracking fund needs to avoid
credit exposure to issuers of ETF-like funds (e.g. ETN)
Preferably at least 3-10 years of track record for the fund itself or the underlying index
Effectiveness in tracking given index
Because a tracking fund doesn’t guarantee the same performance as the underlying asset (or its index), we assess how successful the fund manager is in tracking the particular index. Specifically, we look at “tracking error”, which can be intuitively referred to as the difference between the manager’s performance and the index’s. We only invest in the tracking funds when the fund manager’s performance versus the index’s have a low variance over a reasonable length of time (about 3-10 years).