04 May 2014
Ten Commandments Of ETF Investing
As ETFs have burst on to the scene in recent years and worked their way into the investing mainstream, the number of products available and complexity of exposure offered has increased significantly. Advisors and investors have taken steps to educate themselves on the ins and outs of ETFs, but many are still scrambling to play catch-up and unaware of the complexities these products can present.
What began as a handful of securities seeking to replicate widely-known stock and bond indexes has grown into a lineup of more than 1,000 funds, offering exposure to nearly every asset class, region, and investment strategy imaginable. While this impressive growth has enhanced the arsenal of securities available to ETF investors, it has also created the potential for misuse and made finding the right ticker symbol a bit more challenging. And while ETFs offer countless potential advantages relative to strategies that revolve around mutual funds and individual stocks, there are some potential pitfalls along path to enhanced cost and tax efficiency. Below, we offer up ten pieces of advice that will help to maximize the benefits of exchange-traded products for all types of investors, including tips on minimizing expenses, avoiding potential pitfalls, and picking the right fund for your portfolio.
10. Honor Thy Expense Ratio
The incredible rise of the ETF industry over the last several years has been attributable to a number of different factors. The enhanced tax efficiency of ETFs relative to mutual funds, intraday liquidity, and unparalleled transparency have all played a part in driving significant cash flows into exchange-traded products. But many investors have made the switch to ETFs based on the potential cost savings relative to actively-managed mutual funds, and the expense ratio delta is likely to be at the top of any list comparing mutual funds to ETFs [read ETFs vs. Mutual Funds: The Ultimate Guide].
After converting to ETFs, some investors pat themselves on the back for minimizing expense ratios, especially those buy-and-holders cognizant of the potential impact of compounding costs on a portfolio’s bottom line return. Not everyone realizes that even within the ETF industry, there are often gaps in expense ratios wide enough to drive a truck through. For those truly interested in minimizing expenses, finding the right ETF can make a significant difference. Consider the following portfolio, consisting of six ETFs and diversified across domestic and international equities, fixed income, and commodities:
ETF
Weighting
Expense Ratio
Russell 3000 Index Fund (IWV) 40% 0.21%
EAFE Index Fund (EFA) 10% 0.34%
Emerging Markets Index Fund (EEM) 10% 0.72%
Barclays Aggregate Bond Fund (AGG) 30% 0.24%
Dow Jones-UBS Commodity ETN (DJP) 5% 0.75%
Gold SPDR (GLD) 5% 0.40%
Total 100% 0.32%
The effective expense ratio of 32 basis points is impressive, especially considering that a similar portfolio comprised of actively managed mutual funds could incur upwards of 2.0% annually in management fees. Plenty of investors seeking to minimize expenses make it to this point and are satisfied, but the portfolio outlined above has only scratched the surface of the cost savings available through ETFs. Consider a second portfolio that offers similar asset class exposure (and nearly-identical index exposure):
ETF
Weighting
Expense Ratio
Broad U.S. Market ETF (SCHB) 40% 0.06%
EAFE ETF (VEA) 10% 0.16%
Emerging Markets ETF (VWO) 10% 0.27%
Barclays Aggregate Bond Fund (LAG) 30% 0.1345%
Dow Jones-UBS Commodity ETN (DJCI) 5% 0.50%
COMEX Gold Trust (IAU) 5% 0.25%
Total 100% 0.15%
Without materially altering the asset allocation, the identification of the most cost-efficient ETF options reduced the effective expense ratio by more than half, lowering it to just 15 basis points [see our list of the 25 Cheapest ETFs].
9. Consider The Total Cost Of ETF Investing
When praising the cost efficiency of ETFs or seeking out the cheapest options, many investors focus in only on the expense ratio. But in reality the expense ratio is only one element of the total cost of investing with ETFs; computing a more accurate and complete cost of ETF investing requires consideration of both additional explicit costs and fees that may be incurred during the trading process. Among the other factors that contribute to the total cost of ETF investing are commissions, bid-ask spreads, and perhaps even effective interest rates:
Commissions
Because trading fees are generally measured in absolute dollar terms, the effective percentage this cost component represents can vary significantly. For those investing significant amounts of money with very little turnover, the impact of commissions can be minimal. But for investors using a more active approach, the costs can add up in a hurry. Consider an investor with a $100,000 portfolio who pays $10 to execute every trade. If that investor makes a trade monthly–one buy and one sell order–the annual cost can exceed $200, effectively adding another 25 basis points to the total expense figure. That more than doubles the cost of the ultra-cheap portfolio outlined above.
Taking advantage of free commissions is an easy way to add to your bottom line. Fortunately for ETF investors, there are several options for avoiding trading commissions altogether. Schwab and Vanguard offer commission free ETF trading to their brokerage clients (on their respective lines of ETFs) and iShares has partnered with Fidelity to offer free ETF trading on 25 of the most popular iShares ETFs. Most recently, TD Ameritrade announced free trading on 100 ETFs [see Commission Free ETFs Coming To TD Ameritrade].
Bid-Ask Spreads
Another element of the total cost picture that must be considered isn’t as explicit as expense ratios and commission fees, but can add up rather quickly. Consider an investor who buys 100,000 shares of an ETF at $100.05 when the NAV is an even $100 and closes out the position at $109.95 after the NAV has climbed to $110. While the value of the ETF rose 10%, the bottom line return to the investor–before considering commissions–was about 10 basis points lower. Depending on the holding period on that investment, the bid-ask spread component of the expense equation could dwarf the expense ratio component [read Five Critical Questions To Ask When Investing In ETFs].
Interest Earned
For certain ETFs, there are other more advanced cost components that must be taken into account. Products that utilize derivatives to establish exposure–such as leveraged ETFs and futures-based commodity products–often maintain cash balances on which interest can be earned. The higher the yield earned by uninvested cash held by leveraged and commodity ETFs, the larger the offset to the expense ratio charged by the fund and the lower the actual overall cost. The issuers of leveraged ETFs pride themselves on their ability to offer competitive yields on uninvested cash, understanding that doing so can have a material impact on the bottom line return.
8. Thou Shall Not Use Market Orders Recklessly
While there are numerous advantages of ETFs compared to traditional actively-managed mutual funds, there are some potential drawbacks that must be avoided as well. When dealing with mutual funds, investors buy shares from the issuer at the underlying asset value and redeem them at NAV as well. Unlike mutual funds, ETFs are traded like stocks–between market participants at whatever price clears the market.
The advantage to this system is the enhanced liquidity available to ETF investors, as shares can be traded at anytime throughout the day, and not redeemed only once at the end of the day. But the stock-like trading characteristics of ETFs also create some potential pitfalls that investors must avoid. The assumption that a trade will be executed at NAV is not always a safe one; while there are arbitrage mechanisms in place to ensure that the price of an ETF doesn’t deviate substantially from the underlying net asset value, reckless use of limit orders can potentially put investors in an early hole or erode gains when exiting a position [read Ten Common Mistakes Every ETF Investor Should Avoid].
The combination of market and orders and ETFs can lead to disaster, especially when the fund in question features a relatively low average daily trading volume. Fortunately, limit orders are very simple and cheap to implement, and are very powerful tools for ETF investors.
Lessons From The “Flash Crash”
The events of May 6, 2010 were terrifying for many investors, as an unprecedented chain of events caused many securities–including many ETFs–to temporarily lose nearly all of their value. While many trades were ultimately canceled, a number of investors learned additional lessons about ETF investing the hard way. Many investors with straight stop orders on ETFs watched as values plummeted and stop orders kicked in well below the net asset value of the ETF.
Again, there is a relatively simple solution to prevent against a repeat of such a phenomenon: stop limit orders. “I think you need to replace all your stops with stop limits and be pretty generous with those limits, so as to actually get executed when the market might crater one way or the other,” said Paul Weisbruch, VP of ETF/Options Sales and Trading at Street One Financial, in a recent interview. “So if investors build into their expectations 10 to 25 cents away from their initial stop target and establish stop limits there, at least they will get protected and they won’t have any executions go far away from the actual NAV of the funds, which happened on May 6th.”
When trading ETFs, there is most certainly a potential to get burned by premiums and discounts. But that doesn’t mean that individual investors should be frightened off: there are very simple and powerful tools that can make trading ETFs a lot safer. Don’t be afraid to take advantage of them [see Ten Shocking ETF Charts From The "Flash Crash"].
7. Thou Shall Not Covet Your Neighbor’s Weighting Methodology
The impressive rise of the ETF industry over the last several years has transformed indexes from hypothetical performance benchmarks into investable assets. Not surprisingly, this transformation has brought increased scrutiny to the methodologies used to construct and maintain indexes. Some investors have come to the conclusion that market cap weighting–giving the largest allocation within an index to the company with the largest market capitalization–has some potential drawbacks, including the tendency to overweight overvalued stocks and underweight undervalued securities. A number of firms have attempted to come up with a better mousetrap, rolling ETFs linked to indexes utilizing lesser-known but potentially more appealing weighting strategies:
◾Equal Weighting: Several ETF issuers offer funds linked to equal-weighted indexes, including Rydex and State Street. As the name suggests, equal-weighted indexes afford an equivalent allocation to every component, generally resulting in lower concentration of assets compared to cap-weighted benchmarks. For example, the Rydex Equal Weighted ETF (RSP) gives Exxon Mobil and Apple the same weighting (0.20%) as it does to the other 498 components of the S&P 500.
◾Dividend Weighting: Not to be confused with indexes comprised of dividend-paying companies, this methodology uses cash dividends paid to determine the weighting afforded within an index. Dividend weighting breaks the link between stock price and weight, and can potentially avoid companies that have been “cooking the books” (it’s tough to manipulate dividend payments). This strategy can also result in a tilt towards value stocks, since those are more likely to pay a cash dividend.
◾Earnings Weighting: This strategy is similar to dividend weighting, but ranks each potential index component by earnings. Relative to a cap-weighted benchmark, the earnings-weighted methodology will tend to overweight companies with low price-to-earnings ratios while underweighting those with higher ratios. WisdomTree is the industry pioneer in both dividend-weighted and earnings-weighted ETFs.
◾Revenue Weighting: This methodology focuses not on a bottom line measure of profitability, but on top line sales. Revenue-weighted ETFs seek to capitalize on short-term imbalances when price/revenue ratios exceed a fair level, essentially overweighting stocks with low price-to-sales ratios [see Revenue Weighting: New Twist On An Old Drink].
◾RAFI Weighting: This concept has been made popular by Rob Arnott, founder of Research Affiliates. The idea behind RAFI weighting is to break the link between a security’s weight in an index and its price. Arnott devised a methodology that focuses on four fundamental factors believed to be more accurate measurements of a company’s true size: book value, income, dividends, and sales [see Does Your Portfolio Need A RAFI ETF?].
On the whole, the ETF boom has bolstered the popularity of and familiarity with market cap weighting, as many of the largest ETFs are linked to cap-weighted benchmarks. But the rise of ETFs has also brought increased attention to alternative methodologies.
For most investors, consideration of the most appropriate weighting methodology isn’t a part of the asset allocation process. Once the desired exposure has been identified (e.g., developed market equities or U.S. financial sector), the default choice is often a cap-weighted ETF that focuses on that sector. The weighting methodology isn’t a major consideration primarily because most investors don’t realize the impact this decision can have on bottom line returns. But in many cases, the manner in which weightings are determined can be just as important as the actual securities selected to make up the index. The following ETFs all offer exposure to large cap U.S. stocks, and the overlap between these funds is considerable. In some cases, the underlying names are identical (SPY and RWL both hold the stocks that make up the S&P 500 Index).
ETF
Weighting Methodology
1-Year Return*
PRF RAFI 8.5%
SPY Market Cap 9.8%
RWL Revenue 10.6%
EPS Earnings 10.7%
EQL Equal Sector 11.3%
DLN Dividend 11.5%
RSP Equal 14.5%
*As of September 30, 2010
Investors who held RSP and SPY over the last year maintained exposure to an identical basket of large cap domestic equities. But those with holdings in the Rydex equal-weighted fund generated excess returns of nearly 500 basis points. That relatively large gap drives this point home: the weighting methodology implemented by the related index can have a material impact on an ETF’s total return.
Cap weighting isn’t necessarily an inferior methodology; in certain environments, cap-weighted indexes will outperform similar strategies implementing various other methodologies. But it is only one of the many options available, and many investors may find the benefits of the alternatives to be quite appealing. Investigating the pros and cons of each weighting methodology is a worthwhile endeavor that may end up enhancing bottom line return [see The Guide to ETF Index Weightings].
6. Thou Shall Not Bear False Witness Against ETFs
As ETFs have burst on to the investing scene in recent years, the reception has been overwhelmingly positive. ETFs have been praised for reducing management fees, democratizing entire asset classes and investment strategies, and simplifying the asset allocation process. But there have been some criticisms of ETFs as well. While ETFs are generally simple securities, some investors have failed to grasp the nuances of some of the more complex products, leading them to cry foul when performance didn’t line up with their expectations. More recently, concerns popped up that the ETF structure was inherently unsafe, and that investing in certain products came with excessive risks.
While some of these criticisms seem initially compelling, they don’t have much–if any–basis in fact.
Flash Crash
The Myth: Because ETFs accounted for a big portion of the canceled trades on May 6, some investors became convinced that ETFs were behind the day’s chaos. Several massive ETFs saw prices decline to as low as a penny, and speculation immediately began to swirl around structural flaws in the ETF wrapper [see Ten Shocking ETF Charts From The Flash Crash].
The Truth: ETFs absolutely did account for the majority of canceled trades on May 6, but the erratic behavior of these products wasn’t necessarily indicative of any sort of vulnerability in the ETF structure. Rather, market makers became concerned that if trades on underlying ETF components were canceled, they would get burned. So they understandably pulled out of the market, and liquidity temporarily dried up. Further research has showed that a big trade in E-Mini Futures started a chain of events that caused billions of dollars in market capitalization to be temporarily erased.
ETF Collapse
The Myth: Last month a report surfaced expressing concern that big net short positions in certain ETFs were setting the state for a calamitous collapse that would potentially leave countless investors completely out of luck.
The Truth: There have always been mechanisms in place designed to prevent against an “ETF collapse,” including provisions that require share redemptions to occur with settled shares. There is simply no way for the doomsday scenario outlined to unfold, regardless of how massive the short interest in a fund becomes [see Why An ETF Can't Collapse].
Commodity ETFs
The Myth: Earlier this year BusinessWeek ran a cover story titled Amber Waves of Pain. The magazine’s cover issued a blanket warning against exchange-traded products designed to offer exposure to commodity prices, repeating “Do Not Invest In Commodity ETFs” three times. The feature went on to detail stories of investors who thought they were buying securities that would replicate the hypothetical returns of investing in spot prices, implying that flaws in commodity products led to disappointing returns [read Five Things BusinessWeek Didn't Tell You About Commodity ETFs].
The Truth: Returns of commodity products can and often do vary from the hypothetical change in spot prices. But that isn’t the result of nefarious design on the part of ETF issuers, rather a cold, hard fact of futures-based investing. What the article failed to mention was that the investors profiled apparently failed to perform even the most basic of due diligence, and totally failed to understand the basics of an investment product into which they poured money.
Leveraged ETFs
The Myth: A year before commodity ETFs came under attach, a firestorm raged around leveraged ETFs that seek to deliver daily results corresponding to a multiple of the day’s change in a particular benchmark. The unprecedented volatility of 2008 had caused many leveraged ETFs to lose money over extended periods of time, a result of the daily resetting of leverage. Leveraged ETFs were of being scams designed to dupe investors, and several lawsuits ensued (some of these have since been dismissed). Although much of the misinformation has been cleared up, confusion still remains; to this day some members of the media stubbornly stick to the claim that these securities exhibit massive “tracking error” that indicates their flaws [ETFdb Pro Members can see our Category Report on Leveraged ETFs here ETFdb Pro Members Only].
The Truth: Leveraged ETFs actually perform their stated objectives with impressive efficiency; the confusion surrounding the performance of these products was the result of investors failing to do their homework, and then crying foul when the results they were hoping for didn’t materialize. The daily resetting of exposure definitely creates the potential for “return erosion” when markets seesaw, but it also sets the stage for “return enhancement” in trending markets [see Two Sides To The Compounding Coin].
It’s hard to tell for sure why these attacks on ETFs have become more prevalent–or how they manage to spread so quickly despite the fact that there is no meat to the argument. There are certainly some potential drawbacks to ETFs, and these securities aren’t for everyone. But be careful about some of what you see written–it’s not always true.
5. Thou Shall Not Make Wrongful Use Of The Name “ETF”
When discussing the universe of exchange-traded products now available, many investors group a number of securities under the ETF umbrella, including exchange-traded notes, grantor trusts, holding company depository receipts, and others. While these securities are similar in many ways, there are some structural complexities that can potentially impact returns and shouldn’t be overlooked.
Perhaps the most important distinction to make is between exchange-traded funds and exchange-traded notes. Although these securities are often lumped together as ETFs, they offer exposure to the related asset class in very different ways. ETFs maintain a portfolio that corresponds to an underlying benchmark; for example, the Russell 1000 Index Fund (IWB) holds equity securities that correspond to the Russell 1000 Index. ETNs, on the other hand, are debt securities issued by a financial institution that pay a return linked to the performance of an underlying index. In other words, ETNs don’t actually hold the assets that comprise the underlying index, and are instead promissory notes that pay returns based on the change in a reference benchmark.
ETNs offer investors both advantages and disadvantages. On the positive side, these securities eliminate tracking error that can plague ETFs. Because ETNs are debt instruments linked to an index, there isn’t actually an underlying basket of securities that can deviate from the benchmark. Moreover, achieving commodity exposure through ETNs may offer enhanced tax efficiency relative to otherwise similar exposure achieved through funds that invest in futures contracts [read how Contango Impacts ETFs].
The drawbacks of ETNs are primarily related to the credit risk to which investors are exposed; because these products are debt securities, there exists the potential for investors to be left holding the bag if the financial institution behind the ETN goes under. While some investors write off the possibility that firms like Barclays or UBS–two banks that have issued billions of dollars worth of exchange-traded notes–will go bankrupt, it’s important to be aware of this risk. Lehman serves as a cautionary tale–the bank was an issuer of ETNs at the time of its collapse. In some cases, ETNs can be less efficient from a tax perspective, since distributions are taxed as interest income [see MLP ETFs: Fact And Fiction].
Holding company depository receipts, or HOLDRS, are also often grouped in with ETFs. But these products, offered by Merrill Lynch, are unique in more ways than one. HOLDRS have a unique structure when it comes to voting rights, and there can be unwanted tax ramifications when component companies are acquired. Moreover, HOLDRS are subject to significant concentration of assets among just a few stocks, which can make them vulnerable to company-specific developments [see Five Facts About HOLDRS Every Investor Should Know].
Structure Matters
Even among ETFs, there are some subtle structural differences that can impact the returns delivered by various products. For example, Rydex, WisdomTree, and iPath all offer exchange-traded products designed to reflect movements in the value of the euro relative to the U.S. dollar. But the three products aren’t identical: ERO is structured as an exchange-traded note, FXE is a grantor trust, and EU is an actively-managed ETF. Those distinctions may not mean much to most investors, but the different structures can lead to unique tax treatments, dispersion of counterparty risk, and, ultimately, bottom line returns [see Euro ETFs: Three Different Options].
A distinction can also be drawn between two popular ETFs offering exposure to the S&P 500. The ultra-popular S&P 500 SPDR (SPY) is a unit investment trust (UIT), which means it is forced to hold dividends in cash and exactly replicate the underlying index. The iShares S&P 500 Index Fund (IVV), on the other hand, can reinvest dividends from underlying securities until the distribution date, making it a potentially better play during bull markets.
The bottom line: once the desired exposure has been identified, it’s worth considering the most efficient vehicle for establishing such a position. While the differences between the various options may seem minor, they can (and often do) impact the effective return realized [read Five Ultra Popular ETNs].
4. Thou Shall Not Use “Liquidity Screens”
When searching for the right ETF, many financial advisors and individual investors first narrow down the field of the 1,000-plus products available to U.S. investors to a much smaller list consisting of funds that offer the exposure desired. From there, the first step for many is to implement a “liquidity screen” designed to filter out products that don’t meet a certain volume or asset threshold. The rationale behind including these screens is simple, but flawed. Investors worry that small ETFs will be illiquid, and that establishing or closing out a position will involve navigating wide bid-ask spreads and introduce the potential to get burned by a shallow market [see Best Execution In ETFs, Does Your Custodian Meet It?].
In an attempt to gauge the liquidity of an ETF, many investors rely on average daily trading volume, a readily available and easily understood metric that conveys the frequency with which shares of a particular security trade hands. But trading volumes are backward-looking statistics related to trading activity, and aren’t indicative of the true liquidity available to an investor considering a purchase of the security.
Just as the fair value of an ETF is derived from the value of the underlying securities, so too is a fund’s liquidity linked to the individual components. Because of the nature of the issuance mechanism in place behind ETFs, true liquidity is derived from the stocks (or bonds) that make up the creation basket. For example, the FaithShares Baptist Values Fund (FZB) trades fewer than 2,000 shares daily. But because the underlying holdings consist of large cap domestic equities, investors who know what they are doing could execute a huge trade without incurring significant costs. Under the hood of exchange-traded funds is a somewhat complex mechanism that allows Authorized Participants to create new shares of a fund if sufficient demand exists in the market, potentially resulting in “spontaneous liquidity” for tickers that may otherwise be thinly-traded.
“The liquidity of an ETF is one of the most misunderstood pieces of the entire structure,” writes David Abner in The ETF Handbook [Incidentally, Abner's book is the most thorough and best researched piece on the ETF space that we've seen]. “It is a hotly debated concept primarily because many people do not fully comprehend that ETF valuations are derived as a function of their underlying constituents and that there are alternative ways to create liquidity beyond the use of the ETF itself.” For investors who don’t cut off a huge chunk of the ETF universe due to liquidity deemed to be insufficient, the number of options obviously increases significantly.
Caution must be exercised when trading in low-volume ETFs, but excluding funds from consideration altogether because they don’t meet somewhat arbitrary thresholds can cause investors to overlook a huge chunk of the ETF lineup, potentially scratching off a fund suited to meet one’s investing needs in the process [also Myths About ETF Liquidity].
3. Not All ETFs Are Created Equal
As investors have embraced the many benefits of ETFs, the number of products available to U.S. investors has multiplied. Investors looking for an S&P 500 ETF have three options, not including those products implementing alternative weighting methodologies highlighted above. Those seeking diversified exposure to emerging markets have nearly two dozen different options, each of which offers a relatively similar risk/return profile [also read Emerging Market Bond ETFs Head-To-Head].
For almost any type of exposure identified, investors are likely to have several ETF options. Even within the targeted semiconductor space, there are four options from which to choose. Once investors have narrowed the universe of nearly 1,100 U.S.-listed ETFs down to those that meet their criteria, selecting the best fit can become a bit challenging.
While many ETFs appear similar on the surface, it’s important not to judge a book by its cover. Below, we highlight several factors worthy of consideration when comparing multiple ETFs head-to-head:
◾Expense Ratio: As demonstrated above, the difference in expense ratios between various ETFs can be quite significant, and choosing the fund with the lowest management fees obviously won’t hurt your bottom line returns [also see Five Critical Criteria For Rating ETFs].
◾Tracking Error: It’s a common misconception that replicating an index is a simple task, and that ETFs will always perform spot-on with the underlying benchmark. In reality, however, almost every ETF exhibits some degree of tracking error–a gap between the return on the fund’s price and the return of the related index. Most issuer web sites show the return over 1-year, 3-year, and 5-year periods for both the ETF and the benchmark to which it is linked, making calculation of tracking error relatively straightforward.
◾Distributions: Consideration of distributions can be important for any investor seeking current income, but this metric can also shed some light on the efficiency with which an ETF is managed. ETFs generally offer enhanced tax efficiency relative to mutual funds, as capital gains distributions are less frequent within the ETF structure. So reviewing the distribution history can be a worthwhile step in the comparison process, with ETFs that haven’t made capital gains distributions being more attractive. Again, this information is generally available from the issuer web sites: for example, the history for QQQQ shows that no capital gains distributions have been made recently–a good sign for investors.
◾Yield: When hunting for current return, navigating through the features of each ETF can be a tricky task. Most issuers present the 30-day SEC yield for each fund, a standardized metric that gives an apples-to-apples comparison of the yield that investors can expect [see this article for a good rundown of the various yield metrics associated with ETFs].
◾Structure: As discussed above, the structure utilized by an ETF can have an impact on the ultimate risk/return profile achieved, so it’s worth figuring out whether each potential investment is packaged as a UIT, ETN, grantor trust, or some other structure.
◾Weighting Methodology: Also highlighted above, the weighting methodology utilized by the underlying index can have an impact on the ultimate return realized in an ETF investment. And this isn’t just limited to the equity ETFs; recent innovation in the fixed income space has included the introduction of the first RAFI-weighted bond ETF.
◾Concentration: ETFs are praised for their ability to offer immediate diversification to investors, delivering access to a broad basket of securities through a single ticker. But just like expense ration, the diversification offered by various ETFs can be wildly different. Consider the Financial SPDR (XLF) and Vanguard Financials ETF (VFH), two funds within the Financials Equities ETFdb Category that offer generally similar exposure. An x-ray look at XLF’s holdings shows 81 individual holdings, with about 55% of assets in the top ten. VFH, on the other hand, consists of nearly 500 component stocks, with only about 40% of assets in the top ten. Lower concentration isn’t necessarily always more desirable, but the number of individual holdings and weightings afforded to each are worth looking into.
◾Exposure Type: When considering international equity ETFs in particular, take a look at the breakdown of holdings across both market capitalizations and sectors. While both the iShares MSCI Brazil Index Fund (EWZ) and Market Vectors Brazil Small Cap ETF (BRF) offer exposure to Brazilian equities, the differences between these funds are significant–both in terms of sector exposure and return characteristics. In general, small cap stocks tend to be more of a “pure play” on the local economy, while large caps focused on banks and oil companies can exhibit higher correlations with global equity markets. Again, one isn’t universally superior to the others, but different funds will make more sense for different investors.
2. Thou Shall Buy Commodity ETFs (But Only If You Truly Understand Them)
Commodity ETFs have become tremendously popular securities over the last several years, as the marriage of futures-based investment strategies and the ETF wrapper have democratized an asset class with potentially valuable diversification benefits for countless investors. But commodity ETFs have also attracted a fair amount of scrutiny, even prompting some publications to advise against buying them altogether. But warnings against the use of commodity ETFs seem to stand in sharp contrast to the billions of dollars in cash inflows into these products over the last 18 months. If commodity ETFs are so dangerous and inclined to erode value–as some have implied–why have investors been flocking towards these products in record numbers?
In reality, commodity ETFs offer efficient exposure to an asset class that would otherwise be difficult and costly to access for many investors. And they generally perform exactly as marketed and as presented in fund literature. Unfortunately, the diligence completed by many investors in these products included only reading the name of the fund and making assumptions about the exposure offered and the return that could be reasonably expected. Commodity ETFs can be incredibly powerful tools with a wide range of applications to all sorts of investors–if the nuances and return implications of a futures-based strategy are understood. Those investors who didn’t take the time to figure out how these products work may end up disappointed and looking for someone to blame, a scenario we’ve now seen play out several times.
The vast majority of exchange-traded products available to U.S. investors are relatively straightforward, including sector-specific and country-specific equity funds, as well as dozens of plain vanilla fixed income ETFs. But others are more complex, and thoroughly understanding the factors that will influence the return of each can be a bit challenging. For many investors, commodity ETFs fall into this category; the connection between the slope of the futures curve and the change in price of the United States Oil Fund (USO) may be a hazy one. Understanding the differences in expected returns to the Direxion Daily Financial Bull 3x Shares (FAS) in trending versus seesawing markets is beyond the grasp of some investors. And truly understanding the underpinnings of a product like the Barclays ETN+ Short D Leveraged Inverse S&P 500 Total Return ETN (BXDD) can be difficult even for the most sophisticated investors [also read the Definitive Guide to the United States Commodity Index Fund].
This advice certainly isn’t original, but it is perhaps more valuable now than ever before: if you don’t understand how an ETF or ETN works, don’t touch it with a ten-foot pole. It sounds obvious, but the allegations of fraud against ETFs that have performed exactly how they should–as summarized above–clearly demonstrates that a lot of investors are jumping into products that they don’t understand a bit. If you don’t understand the risks of an ETF after studying the fund literature for a few minutes, don’t hesitate to walk away and find a security with which you are more comfortable. At a certain point, the responsibility to protect investors falls to the investors themselves–and sometimes it seems as if proper discretion is in short supply. There is a tremendous amount of educational material out there in the ETF industry, including pieces from issuers and third parties. Make sure to take advantage of it [ETFdb Pro Members can read the Precious Metals Category Report here ETFdb Pro Members Only for more information].
1. Thou Shall Take Advantage Of Free ETF Resources
Navigating the world of ETFs can be a daunting task, particularly for those investors and advisors who have primarily utilized mutual funds historically. But there are a number of powerful, free resources out there that have the potential to make ETF investing a much easier process. Some of the free ETF tools offered by ETFdb include:
◾ETF Screener: Detailed descriptive information on all U.S.-listed products allows investors to slice-and-dice the ETF universe in countless ways, including by asset class, region, sector, bond and currency types, index tracked, and expense ratio.
◾Mutual Fund To ETF Converter: For investors looking to make the switch from mutual funds to ETFs, this tool can help to simplify the conversion process. Entering in a mutual fund ticker directs users to two lists of ETF alternative, including those that seek to replicate the mutual fund’s benchmark and others that fall into the same category [read more about the tool's methodology].
◾ETF Country Exposure Tool: For investors looking for international equity exposure, this resource can be quite valuable. Highlighting a country from our global map directs to a list of ETFs with exposure to that country, including both “pure plays” and funds that offer only partial exposure [you may be surprised at how many ETFs include exposure to Kazakhstan]
◾ETF Stock Exposure Tool: Figuring out which ETFs have considerable exposure to a particular stock is now incredibly easy–simply enter the ticker into this tool and find a list of all the equity ETFs with a big weighting [there are a ton of other great ETF tools out there as well; check out our list of 50 valuable online ETF resources].
What began as a handful of securities seeking to replicate widely-known stock and bond indexes has grown into a lineup of more than 1,000 funds, offering exposure to nearly every asset class, region, and investment strategy imaginable. While this impressive growth has enhanced the arsenal of securities available to ETF investors, it has also created the potential for misuse and made finding the right ticker symbol a bit more challenging. And while ETFs offer countless potential advantages relative to strategies that revolve around mutual funds and individual stocks, there are some potential pitfalls along path to enhanced cost and tax efficiency. Below, we offer up ten pieces of advice that will help to maximize the benefits of exchange-traded products for all types of investors, including tips on minimizing expenses, avoiding potential pitfalls, and picking the right fund for your portfolio.
10. Honor Thy Expense Ratio
The incredible rise of the ETF industry over the last several years has been attributable to a number of different factors. The enhanced tax efficiency of ETFs relative to mutual funds, intraday liquidity, and unparalleled transparency have all played a part in driving significant cash flows into exchange-traded products. But many investors have made the switch to ETFs based on the potential cost savings relative to actively-managed mutual funds, and the expense ratio delta is likely to be at the top of any list comparing mutual funds to ETFs [read ETFs vs. Mutual Funds: The Ultimate Guide].
After converting to ETFs, some investors pat themselves on the back for minimizing expense ratios, especially those buy-and-holders cognizant of the potential impact of compounding costs on a portfolio’s bottom line return. Not everyone realizes that even within the ETF industry, there are often gaps in expense ratios wide enough to drive a truck through. For those truly interested in minimizing expenses, finding the right ETF can make a significant difference. Consider the following portfolio, consisting of six ETFs and diversified across domestic and international equities, fixed income, and commodities:
ETF
Weighting
Expense Ratio
Russell 3000 Index Fund (IWV) 40% 0.21%
EAFE Index Fund (EFA) 10% 0.34%
Emerging Markets Index Fund (EEM) 10% 0.72%
Barclays Aggregate Bond Fund (AGG) 30% 0.24%
Dow Jones-UBS Commodity ETN (DJP) 5% 0.75%
Gold SPDR (GLD) 5% 0.40%
Total 100% 0.32%
The effective expense ratio of 32 basis points is impressive, especially considering that a similar portfolio comprised of actively managed mutual funds could incur upwards of 2.0% annually in management fees. Plenty of investors seeking to minimize expenses make it to this point and are satisfied, but the portfolio outlined above has only scratched the surface of the cost savings available through ETFs. Consider a second portfolio that offers similar asset class exposure (and nearly-identical index exposure):
ETF
Weighting
Expense Ratio
Broad U.S. Market ETF (SCHB) 40% 0.06%
EAFE ETF (VEA) 10% 0.16%
Emerging Markets ETF (VWO) 10% 0.27%
Barclays Aggregate Bond Fund (LAG) 30% 0.1345%
Dow Jones-UBS Commodity ETN (DJCI) 5% 0.50%
COMEX Gold Trust (IAU) 5% 0.25%
Total 100% 0.15%
Without materially altering the asset allocation, the identification of the most cost-efficient ETF options reduced the effective expense ratio by more than half, lowering it to just 15 basis points [see our list of the 25 Cheapest ETFs].
9. Consider The Total Cost Of ETF Investing
When praising the cost efficiency of ETFs or seeking out the cheapest options, many investors focus in only on the expense ratio. But in reality the expense ratio is only one element of the total cost of investing with ETFs; computing a more accurate and complete cost of ETF investing requires consideration of both additional explicit costs and fees that may be incurred during the trading process. Among the other factors that contribute to the total cost of ETF investing are commissions, bid-ask spreads, and perhaps even effective interest rates:
Commissions
Because trading fees are generally measured in absolute dollar terms, the effective percentage this cost component represents can vary significantly. For those investing significant amounts of money with very little turnover, the impact of commissions can be minimal. But for investors using a more active approach, the costs can add up in a hurry. Consider an investor with a $100,000 portfolio who pays $10 to execute every trade. If that investor makes a trade monthly–one buy and one sell order–the annual cost can exceed $200, effectively adding another 25 basis points to the total expense figure. That more than doubles the cost of the ultra-cheap portfolio outlined above.
Taking advantage of free commissions is an easy way to add to your bottom line. Fortunately for ETF investors, there are several options for avoiding trading commissions altogether. Schwab and Vanguard offer commission free ETF trading to their brokerage clients (on their respective lines of ETFs) and iShares has partnered with Fidelity to offer free ETF trading on 25 of the most popular iShares ETFs. Most recently, TD Ameritrade announced free trading on 100 ETFs [see Commission Free ETFs Coming To TD Ameritrade].
Bid-Ask Spreads
Another element of the total cost picture that must be considered isn’t as explicit as expense ratios and commission fees, but can add up rather quickly. Consider an investor who buys 100,000 shares of an ETF at $100.05 when the NAV is an even $100 and closes out the position at $109.95 after the NAV has climbed to $110. While the value of the ETF rose 10%, the bottom line return to the investor–before considering commissions–was about 10 basis points lower. Depending on the holding period on that investment, the bid-ask spread component of the expense equation could dwarf the expense ratio component [read Five Critical Questions To Ask When Investing In ETFs].
Interest Earned
For certain ETFs, there are other more advanced cost components that must be taken into account. Products that utilize derivatives to establish exposure–such as leveraged ETFs and futures-based commodity products–often maintain cash balances on which interest can be earned. The higher the yield earned by uninvested cash held by leveraged and commodity ETFs, the larger the offset to the expense ratio charged by the fund and the lower the actual overall cost. The issuers of leveraged ETFs pride themselves on their ability to offer competitive yields on uninvested cash, understanding that doing so can have a material impact on the bottom line return.
8. Thou Shall Not Use Market Orders Recklessly
While there are numerous advantages of ETFs compared to traditional actively-managed mutual funds, there are some potential drawbacks that must be avoided as well. When dealing with mutual funds, investors buy shares from the issuer at the underlying asset value and redeem them at NAV as well. Unlike mutual funds, ETFs are traded like stocks–between market participants at whatever price clears the market.
The advantage to this system is the enhanced liquidity available to ETF investors, as shares can be traded at anytime throughout the day, and not redeemed only once at the end of the day. But the stock-like trading characteristics of ETFs also create some potential pitfalls that investors must avoid. The assumption that a trade will be executed at NAV is not always a safe one; while there are arbitrage mechanisms in place to ensure that the price of an ETF doesn’t deviate substantially from the underlying net asset value, reckless use of limit orders can potentially put investors in an early hole or erode gains when exiting a position [read Ten Common Mistakes Every ETF Investor Should Avoid].
The combination of market and orders and ETFs can lead to disaster, especially when the fund in question features a relatively low average daily trading volume. Fortunately, limit orders are very simple and cheap to implement, and are very powerful tools for ETF investors.
Lessons From The “Flash Crash”
The events of May 6, 2010 were terrifying for many investors, as an unprecedented chain of events caused many securities–including many ETFs–to temporarily lose nearly all of their value. While many trades were ultimately canceled, a number of investors learned additional lessons about ETF investing the hard way. Many investors with straight stop orders on ETFs watched as values plummeted and stop orders kicked in well below the net asset value of the ETF.
Again, there is a relatively simple solution to prevent against a repeat of such a phenomenon: stop limit orders. “I think you need to replace all your stops with stop limits and be pretty generous with those limits, so as to actually get executed when the market might crater one way or the other,” said Paul Weisbruch, VP of ETF/Options Sales and Trading at Street One Financial, in a recent interview. “So if investors build into their expectations 10 to 25 cents away from their initial stop target and establish stop limits there, at least they will get protected and they won’t have any executions go far away from the actual NAV of the funds, which happened on May 6th.”
When trading ETFs, there is most certainly a potential to get burned by premiums and discounts. But that doesn’t mean that individual investors should be frightened off: there are very simple and powerful tools that can make trading ETFs a lot safer. Don’t be afraid to take advantage of them [see Ten Shocking ETF Charts From The "Flash Crash"].
7. Thou Shall Not Covet Your Neighbor’s Weighting Methodology
The impressive rise of the ETF industry over the last several years has transformed indexes from hypothetical performance benchmarks into investable assets. Not surprisingly, this transformation has brought increased scrutiny to the methodologies used to construct and maintain indexes. Some investors have come to the conclusion that market cap weighting–giving the largest allocation within an index to the company with the largest market capitalization–has some potential drawbacks, including the tendency to overweight overvalued stocks and underweight undervalued securities. A number of firms have attempted to come up with a better mousetrap, rolling ETFs linked to indexes utilizing lesser-known but potentially more appealing weighting strategies:
◾Equal Weighting: Several ETF issuers offer funds linked to equal-weighted indexes, including Rydex and State Street. As the name suggests, equal-weighted indexes afford an equivalent allocation to every component, generally resulting in lower concentration of assets compared to cap-weighted benchmarks. For example, the Rydex Equal Weighted ETF (RSP) gives Exxon Mobil and Apple the same weighting (0.20%) as it does to the other 498 components of the S&P 500.
◾Dividend Weighting: Not to be confused with indexes comprised of dividend-paying companies, this methodology uses cash dividends paid to determine the weighting afforded within an index. Dividend weighting breaks the link between stock price and weight, and can potentially avoid companies that have been “cooking the books” (it’s tough to manipulate dividend payments). This strategy can also result in a tilt towards value stocks, since those are more likely to pay a cash dividend.
◾Earnings Weighting: This strategy is similar to dividend weighting, but ranks each potential index component by earnings. Relative to a cap-weighted benchmark, the earnings-weighted methodology will tend to overweight companies with low price-to-earnings ratios while underweighting those with higher ratios. WisdomTree is the industry pioneer in both dividend-weighted and earnings-weighted ETFs.
◾Revenue Weighting: This methodology focuses not on a bottom line measure of profitability, but on top line sales. Revenue-weighted ETFs seek to capitalize on short-term imbalances when price/revenue ratios exceed a fair level, essentially overweighting stocks with low price-to-sales ratios [see Revenue Weighting: New Twist On An Old Drink].
◾RAFI Weighting: This concept has been made popular by Rob Arnott, founder of Research Affiliates. The idea behind RAFI weighting is to break the link between a security’s weight in an index and its price. Arnott devised a methodology that focuses on four fundamental factors believed to be more accurate measurements of a company’s true size: book value, income, dividends, and sales [see Does Your Portfolio Need A RAFI ETF?].
On the whole, the ETF boom has bolstered the popularity of and familiarity with market cap weighting, as many of the largest ETFs are linked to cap-weighted benchmarks. But the rise of ETFs has also brought increased attention to alternative methodologies.
For most investors, consideration of the most appropriate weighting methodology isn’t a part of the asset allocation process. Once the desired exposure has been identified (e.g., developed market equities or U.S. financial sector), the default choice is often a cap-weighted ETF that focuses on that sector. The weighting methodology isn’t a major consideration primarily because most investors don’t realize the impact this decision can have on bottom line returns. But in many cases, the manner in which weightings are determined can be just as important as the actual securities selected to make up the index. The following ETFs all offer exposure to large cap U.S. stocks, and the overlap between these funds is considerable. In some cases, the underlying names are identical (SPY and RWL both hold the stocks that make up the S&P 500 Index).
ETF
Weighting Methodology
1-Year Return*
PRF RAFI 8.5%
SPY Market Cap 9.8%
RWL Revenue 10.6%
EPS Earnings 10.7%
EQL Equal Sector 11.3%
DLN Dividend 11.5%
RSP Equal 14.5%
*As of September 30, 2010
Investors who held RSP and SPY over the last year maintained exposure to an identical basket of large cap domestic equities. But those with holdings in the Rydex equal-weighted fund generated excess returns of nearly 500 basis points. That relatively large gap drives this point home: the weighting methodology implemented by the related index can have a material impact on an ETF’s total return.
Cap weighting isn’t necessarily an inferior methodology; in certain environments, cap-weighted indexes will outperform similar strategies implementing various other methodologies. But it is only one of the many options available, and many investors may find the benefits of the alternatives to be quite appealing. Investigating the pros and cons of each weighting methodology is a worthwhile endeavor that may end up enhancing bottom line return [see The Guide to ETF Index Weightings].
6. Thou Shall Not Bear False Witness Against ETFs
As ETFs have burst on to the investing scene in recent years, the reception has been overwhelmingly positive. ETFs have been praised for reducing management fees, democratizing entire asset classes and investment strategies, and simplifying the asset allocation process. But there have been some criticisms of ETFs as well. While ETFs are generally simple securities, some investors have failed to grasp the nuances of some of the more complex products, leading them to cry foul when performance didn’t line up with their expectations. More recently, concerns popped up that the ETF structure was inherently unsafe, and that investing in certain products came with excessive risks.
While some of these criticisms seem initially compelling, they don’t have much–if any–basis in fact.
Flash Crash
The Myth: Because ETFs accounted for a big portion of the canceled trades on May 6, some investors became convinced that ETFs were behind the day’s chaos. Several massive ETFs saw prices decline to as low as a penny, and speculation immediately began to swirl around structural flaws in the ETF wrapper [see Ten Shocking ETF Charts From The Flash Crash].
The Truth: ETFs absolutely did account for the majority of canceled trades on May 6, but the erratic behavior of these products wasn’t necessarily indicative of any sort of vulnerability in the ETF structure. Rather, market makers became concerned that if trades on underlying ETF components were canceled, they would get burned. So they understandably pulled out of the market, and liquidity temporarily dried up. Further research has showed that a big trade in E-Mini Futures started a chain of events that caused billions of dollars in market capitalization to be temporarily erased.
ETF Collapse
The Myth: Last month a report surfaced expressing concern that big net short positions in certain ETFs were setting the state for a calamitous collapse that would potentially leave countless investors completely out of luck.
The Truth: There have always been mechanisms in place designed to prevent against an “ETF collapse,” including provisions that require share redemptions to occur with settled shares. There is simply no way for the doomsday scenario outlined to unfold, regardless of how massive the short interest in a fund becomes [see Why An ETF Can't Collapse].
Commodity ETFs
The Myth: Earlier this year BusinessWeek ran a cover story titled Amber Waves of Pain. The magazine’s cover issued a blanket warning against exchange-traded products designed to offer exposure to commodity prices, repeating “Do Not Invest In Commodity ETFs” three times. The feature went on to detail stories of investors who thought they were buying securities that would replicate the hypothetical returns of investing in spot prices, implying that flaws in commodity products led to disappointing returns [read Five Things BusinessWeek Didn't Tell You About Commodity ETFs].
The Truth: Returns of commodity products can and often do vary from the hypothetical change in spot prices. But that isn’t the result of nefarious design on the part of ETF issuers, rather a cold, hard fact of futures-based investing. What the article failed to mention was that the investors profiled apparently failed to perform even the most basic of due diligence, and totally failed to understand the basics of an investment product into which they poured money.
Leveraged ETFs
The Myth: A year before commodity ETFs came under attach, a firestorm raged around leveraged ETFs that seek to deliver daily results corresponding to a multiple of the day’s change in a particular benchmark. The unprecedented volatility of 2008 had caused many leveraged ETFs to lose money over extended periods of time, a result of the daily resetting of leverage. Leveraged ETFs were of being scams designed to dupe investors, and several lawsuits ensued (some of these have since been dismissed). Although much of the misinformation has been cleared up, confusion still remains; to this day some members of the media stubbornly stick to the claim that these securities exhibit massive “tracking error” that indicates their flaws [ETFdb Pro Members can see our Category Report on Leveraged ETFs here ETFdb Pro Members Only].
The Truth: Leveraged ETFs actually perform their stated objectives with impressive efficiency; the confusion surrounding the performance of these products was the result of investors failing to do their homework, and then crying foul when the results they were hoping for didn’t materialize. The daily resetting of exposure definitely creates the potential for “return erosion” when markets seesaw, but it also sets the stage for “return enhancement” in trending markets [see Two Sides To The Compounding Coin].
It’s hard to tell for sure why these attacks on ETFs have become more prevalent–or how they manage to spread so quickly despite the fact that there is no meat to the argument. There are certainly some potential drawbacks to ETFs, and these securities aren’t for everyone. But be careful about some of what you see written–it’s not always true.
5. Thou Shall Not Make Wrongful Use Of The Name “ETF”
When discussing the universe of exchange-traded products now available, many investors group a number of securities under the ETF umbrella, including exchange-traded notes, grantor trusts, holding company depository receipts, and others. While these securities are similar in many ways, there are some structural complexities that can potentially impact returns and shouldn’t be overlooked.
Perhaps the most important distinction to make is between exchange-traded funds and exchange-traded notes. Although these securities are often lumped together as ETFs, they offer exposure to the related asset class in very different ways. ETFs maintain a portfolio that corresponds to an underlying benchmark; for example, the Russell 1000 Index Fund (IWB) holds equity securities that correspond to the Russell 1000 Index. ETNs, on the other hand, are debt securities issued by a financial institution that pay a return linked to the performance of an underlying index. In other words, ETNs don’t actually hold the assets that comprise the underlying index, and are instead promissory notes that pay returns based on the change in a reference benchmark.
ETNs offer investors both advantages and disadvantages. On the positive side, these securities eliminate tracking error that can plague ETFs. Because ETNs are debt instruments linked to an index, there isn’t actually an underlying basket of securities that can deviate from the benchmark. Moreover, achieving commodity exposure through ETNs may offer enhanced tax efficiency relative to otherwise similar exposure achieved through funds that invest in futures contracts [read how Contango Impacts ETFs].
The drawbacks of ETNs are primarily related to the credit risk to which investors are exposed; because these products are debt securities, there exists the potential for investors to be left holding the bag if the financial institution behind the ETN goes under. While some investors write off the possibility that firms like Barclays or UBS–two banks that have issued billions of dollars worth of exchange-traded notes–will go bankrupt, it’s important to be aware of this risk. Lehman serves as a cautionary tale–the bank was an issuer of ETNs at the time of its collapse. In some cases, ETNs can be less efficient from a tax perspective, since distributions are taxed as interest income [see MLP ETFs: Fact And Fiction].
Holding company depository receipts, or HOLDRS, are also often grouped in with ETFs. But these products, offered by Merrill Lynch, are unique in more ways than one. HOLDRS have a unique structure when it comes to voting rights, and there can be unwanted tax ramifications when component companies are acquired. Moreover, HOLDRS are subject to significant concentration of assets among just a few stocks, which can make them vulnerable to company-specific developments [see Five Facts About HOLDRS Every Investor Should Know].
Structure Matters
Even among ETFs, there are some subtle structural differences that can impact the returns delivered by various products. For example, Rydex, WisdomTree, and iPath all offer exchange-traded products designed to reflect movements in the value of the euro relative to the U.S. dollar. But the three products aren’t identical: ERO is structured as an exchange-traded note, FXE is a grantor trust, and EU is an actively-managed ETF. Those distinctions may not mean much to most investors, but the different structures can lead to unique tax treatments, dispersion of counterparty risk, and, ultimately, bottom line returns [see Euro ETFs: Three Different Options].
A distinction can also be drawn between two popular ETFs offering exposure to the S&P 500. The ultra-popular S&P 500 SPDR (SPY) is a unit investment trust (UIT), which means it is forced to hold dividends in cash and exactly replicate the underlying index. The iShares S&P 500 Index Fund (IVV), on the other hand, can reinvest dividends from underlying securities until the distribution date, making it a potentially better play during bull markets.
The bottom line: once the desired exposure has been identified, it’s worth considering the most efficient vehicle for establishing such a position. While the differences between the various options may seem minor, they can (and often do) impact the effective return realized [read Five Ultra Popular ETNs].
4. Thou Shall Not Use “Liquidity Screens”
When searching for the right ETF, many financial advisors and individual investors first narrow down the field of the 1,000-plus products available to U.S. investors to a much smaller list consisting of funds that offer the exposure desired. From there, the first step for many is to implement a “liquidity screen” designed to filter out products that don’t meet a certain volume or asset threshold. The rationale behind including these screens is simple, but flawed. Investors worry that small ETFs will be illiquid, and that establishing or closing out a position will involve navigating wide bid-ask spreads and introduce the potential to get burned by a shallow market [see Best Execution In ETFs, Does Your Custodian Meet It?].
In an attempt to gauge the liquidity of an ETF, many investors rely on average daily trading volume, a readily available and easily understood metric that conveys the frequency with which shares of a particular security trade hands. But trading volumes are backward-looking statistics related to trading activity, and aren’t indicative of the true liquidity available to an investor considering a purchase of the security.
Just as the fair value of an ETF is derived from the value of the underlying securities, so too is a fund’s liquidity linked to the individual components. Because of the nature of the issuance mechanism in place behind ETFs, true liquidity is derived from the stocks (or bonds) that make up the creation basket. For example, the FaithShares Baptist Values Fund (FZB) trades fewer than 2,000 shares daily. But because the underlying holdings consist of large cap domestic equities, investors who know what they are doing could execute a huge trade without incurring significant costs. Under the hood of exchange-traded funds is a somewhat complex mechanism that allows Authorized Participants to create new shares of a fund if sufficient demand exists in the market, potentially resulting in “spontaneous liquidity” for tickers that may otherwise be thinly-traded.
“The liquidity of an ETF is one of the most misunderstood pieces of the entire structure,” writes David Abner in The ETF Handbook [Incidentally, Abner's book is the most thorough and best researched piece on the ETF space that we've seen]. “It is a hotly debated concept primarily because many people do not fully comprehend that ETF valuations are derived as a function of their underlying constituents and that there are alternative ways to create liquidity beyond the use of the ETF itself.” For investors who don’t cut off a huge chunk of the ETF universe due to liquidity deemed to be insufficient, the number of options obviously increases significantly.
Caution must be exercised when trading in low-volume ETFs, but excluding funds from consideration altogether because they don’t meet somewhat arbitrary thresholds can cause investors to overlook a huge chunk of the ETF lineup, potentially scratching off a fund suited to meet one’s investing needs in the process [also Myths About ETF Liquidity].
3. Not All ETFs Are Created Equal
As investors have embraced the many benefits of ETFs, the number of products available to U.S. investors has multiplied. Investors looking for an S&P 500 ETF have three options, not including those products implementing alternative weighting methodologies highlighted above. Those seeking diversified exposure to emerging markets have nearly two dozen different options, each of which offers a relatively similar risk/return profile [also read Emerging Market Bond ETFs Head-To-Head].
For almost any type of exposure identified, investors are likely to have several ETF options. Even within the targeted semiconductor space, there are four options from which to choose. Once investors have narrowed the universe of nearly 1,100 U.S.-listed ETFs down to those that meet their criteria, selecting the best fit can become a bit challenging.
While many ETFs appear similar on the surface, it’s important not to judge a book by its cover. Below, we highlight several factors worthy of consideration when comparing multiple ETFs head-to-head:
◾Expense Ratio: As demonstrated above, the difference in expense ratios between various ETFs can be quite significant, and choosing the fund with the lowest management fees obviously won’t hurt your bottom line returns [also see Five Critical Criteria For Rating ETFs].
◾Tracking Error: It’s a common misconception that replicating an index is a simple task, and that ETFs will always perform spot-on with the underlying benchmark. In reality, however, almost every ETF exhibits some degree of tracking error–a gap between the return on the fund’s price and the return of the related index. Most issuer web sites show the return over 1-year, 3-year, and 5-year periods for both the ETF and the benchmark to which it is linked, making calculation of tracking error relatively straightforward.
◾Distributions: Consideration of distributions can be important for any investor seeking current income, but this metric can also shed some light on the efficiency with which an ETF is managed. ETFs generally offer enhanced tax efficiency relative to mutual funds, as capital gains distributions are less frequent within the ETF structure. So reviewing the distribution history can be a worthwhile step in the comparison process, with ETFs that haven’t made capital gains distributions being more attractive. Again, this information is generally available from the issuer web sites: for example, the history for QQQQ shows that no capital gains distributions have been made recently–a good sign for investors.
◾Yield: When hunting for current return, navigating through the features of each ETF can be a tricky task. Most issuers present the 30-day SEC yield for each fund, a standardized metric that gives an apples-to-apples comparison of the yield that investors can expect [see this article for a good rundown of the various yield metrics associated with ETFs].
◾Structure: As discussed above, the structure utilized by an ETF can have an impact on the ultimate risk/return profile achieved, so it’s worth figuring out whether each potential investment is packaged as a UIT, ETN, grantor trust, or some other structure.
◾Weighting Methodology: Also highlighted above, the weighting methodology utilized by the underlying index can have an impact on the ultimate return realized in an ETF investment. And this isn’t just limited to the equity ETFs; recent innovation in the fixed income space has included the introduction of the first RAFI-weighted bond ETF.
◾Concentration: ETFs are praised for their ability to offer immediate diversification to investors, delivering access to a broad basket of securities through a single ticker. But just like expense ration, the diversification offered by various ETFs can be wildly different. Consider the Financial SPDR (XLF) and Vanguard Financials ETF (VFH), two funds within the Financials Equities ETFdb Category that offer generally similar exposure. An x-ray look at XLF’s holdings shows 81 individual holdings, with about 55% of assets in the top ten. VFH, on the other hand, consists of nearly 500 component stocks, with only about 40% of assets in the top ten. Lower concentration isn’t necessarily always more desirable, but the number of individual holdings and weightings afforded to each are worth looking into.
◾Exposure Type: When considering international equity ETFs in particular, take a look at the breakdown of holdings across both market capitalizations and sectors. While both the iShares MSCI Brazil Index Fund (EWZ) and Market Vectors Brazil Small Cap ETF (BRF) offer exposure to Brazilian equities, the differences between these funds are significant–both in terms of sector exposure and return characteristics. In general, small cap stocks tend to be more of a “pure play” on the local economy, while large caps focused on banks and oil companies can exhibit higher correlations with global equity markets. Again, one isn’t universally superior to the others, but different funds will make more sense for different investors.
2. Thou Shall Buy Commodity ETFs (But Only If You Truly Understand Them)
Commodity ETFs have become tremendously popular securities over the last several years, as the marriage of futures-based investment strategies and the ETF wrapper have democratized an asset class with potentially valuable diversification benefits for countless investors. But commodity ETFs have also attracted a fair amount of scrutiny, even prompting some publications to advise against buying them altogether. But warnings against the use of commodity ETFs seem to stand in sharp contrast to the billions of dollars in cash inflows into these products over the last 18 months. If commodity ETFs are so dangerous and inclined to erode value–as some have implied–why have investors been flocking towards these products in record numbers?
In reality, commodity ETFs offer efficient exposure to an asset class that would otherwise be difficult and costly to access for many investors. And they generally perform exactly as marketed and as presented in fund literature. Unfortunately, the diligence completed by many investors in these products included only reading the name of the fund and making assumptions about the exposure offered and the return that could be reasonably expected. Commodity ETFs can be incredibly powerful tools with a wide range of applications to all sorts of investors–if the nuances and return implications of a futures-based strategy are understood. Those investors who didn’t take the time to figure out how these products work may end up disappointed and looking for someone to blame, a scenario we’ve now seen play out several times.
The vast majority of exchange-traded products available to U.S. investors are relatively straightforward, including sector-specific and country-specific equity funds, as well as dozens of plain vanilla fixed income ETFs. But others are more complex, and thoroughly understanding the factors that will influence the return of each can be a bit challenging. For many investors, commodity ETFs fall into this category; the connection between the slope of the futures curve and the change in price of the United States Oil Fund (USO) may be a hazy one. Understanding the differences in expected returns to the Direxion Daily Financial Bull 3x Shares (FAS) in trending versus seesawing markets is beyond the grasp of some investors. And truly understanding the underpinnings of a product like the Barclays ETN+ Short D Leveraged Inverse S&P 500 Total Return ETN (BXDD) can be difficult even for the most sophisticated investors [also read the Definitive Guide to the United States Commodity Index Fund].
This advice certainly isn’t original, but it is perhaps more valuable now than ever before: if you don’t understand how an ETF or ETN works, don’t touch it with a ten-foot pole. It sounds obvious, but the allegations of fraud against ETFs that have performed exactly how they should–as summarized above–clearly demonstrates that a lot of investors are jumping into products that they don’t understand a bit. If you don’t understand the risks of an ETF after studying the fund literature for a few minutes, don’t hesitate to walk away and find a security with which you are more comfortable. At a certain point, the responsibility to protect investors falls to the investors themselves–and sometimes it seems as if proper discretion is in short supply. There is a tremendous amount of educational material out there in the ETF industry, including pieces from issuers and third parties. Make sure to take advantage of it [ETFdb Pro Members can read the Precious Metals Category Report here ETFdb Pro Members Only for more information].
1. Thou Shall Take Advantage Of Free ETF Resources
Navigating the world of ETFs can be a daunting task, particularly for those investors and advisors who have primarily utilized mutual funds historically. But there are a number of powerful, free resources out there that have the potential to make ETF investing a much easier process. Some of the free ETF tools offered by ETFdb include:
◾ETF Screener: Detailed descriptive information on all U.S.-listed products allows investors to slice-and-dice the ETF universe in countless ways, including by asset class, region, sector, bond and currency types, index tracked, and expense ratio.
◾Mutual Fund To ETF Converter: For investors looking to make the switch from mutual funds to ETFs, this tool can help to simplify the conversion process. Entering in a mutual fund ticker directs users to two lists of ETF alternative, including those that seek to replicate the mutual fund’s benchmark and others that fall into the same category [read more about the tool's methodology].
◾ETF Country Exposure Tool: For investors looking for international equity exposure, this resource can be quite valuable. Highlighting a country from our global map directs to a list of ETFs with exposure to that country, including both “pure plays” and funds that offer only partial exposure [you may be surprised at how many ETFs include exposure to Kazakhstan]
◾ETF Stock Exposure Tool: Figuring out which ETFs have considerable exposure to a particular stock is now incredibly easy–simply enter the ticker into this tool and find a list of all the equity ETFs with a big weighting [there are a ton of other great ETF tools out there as well; check out our list of 50 valuable online ETF resources].
Labels: ETF
