How To Pick The Right ETF

ETFs are one of the greatest financial product inventions investors have ever seen. They’re low-cost, tax-efficient and transparent. Maybe best of all they’re extremely convenient, offering diversified or niche strategies that would have been nearly impossible for most investors to put together themselves in the past.

Investors have taken notice based on the fact that there’s now $3 trillion or so invested in these products (courtesy of FT):

The downside of their popularity is the fact that there’s been an explosion in the number of ETFs to choose from as there are now close to 2,000 of them. Plenty of investors could use some help to understand the products, strategies, liquidity profile and functionality of the wide range of ETFs out there.

Enter the new book, The Institutional ETF Toolbox, by Bloomberg’s Eric Balchunas.

This is THE book investors — professional or otherwise — should read to understand ETFs, their history, how they function, how institutions and advisors are using them and which ones are available in each category.

One of the more helpful sections in the book deals with how to perform due diligence on ETFs. Because there are so many ETFs out there now many investors may be investing in strategies with risks they don’t truly understand or may not even realize they’re taking. Balchunas lists five factors to consider when performing due diligence on an ETF. Here they are along with a few short questions for each:

1. Exposure. What are the holdings? How is the index or strategy constructed? What are the characteristics of the holdings? How concentrated are the holdings?

2. Cost. What’s the expense ratio? How much tracking error is there from the underlying index? How much turnover is there and what are the trading costs? Does the ETF trade at a premium or a discount to its NAV? What’s the tax structure of the ETF?

3. Liquidity. What’s the typical volume of shares traded in the ETF? How easy is it to move in and out of positions in the fund at your trading size? What is the liquidity profile of the underlying holdings?

4. Risk. How volatile is the ETF or strategy compared to a more plain vanilla holding? Does the fund offer the exposure you’re looking for or are there unnecessary risks being taken? Is there a more efficient or cost effective option available? How many assets are in the ETF? Is the fund at risk of closure?

5. Regulatory Structure. Is this an open-ended fund (the majority are) or is this an ETN (Exchange traded note which usually includes funds that invest in MLPs, the VIX or commodities for tax purposes)?

I’ve only scratched the surface here as Eric goes into much further detail on each of these topics in the book. But this gives you a good idea about the considerations investors should have when allocating to an ETF. Picking the right ETF isn’t easy because there’s not always a right or wrong answer.

Here’s Eric on how to think about this task:

Choosing an ETF is like shopping for a pair of shoes. Just as there is no right or wrong shoe at the shoe store, there is no “right” or “wrong” ETF. It depends on what your needs are and what your style is. That’s why there is no magic bullet or star rating that proves one ETF is better than another for every type of investor in every type of scenario. There are several ETFs that would be horrible long-term investments for my mom, but they are perfect products for a hedge fund doing a short-term trade.

This is why ETF due diligence is both an art and a science. The process is going to be driven by the immediate and long-term goals and preferences of the investors. While exposure should be the most important consideration, beyond that it will depend. For example, liquidity may trump cost for a pension looking to do a manager transition or rebalance the portfolio, while index weightings may trump liquidity for an asset manager making a strategic allocation. That’s why it is important to know what your goal is before picking an ETF.

There’s a lot more nuance here than meets the eye. I’m guessing any investor who actually looks into these five categories before making a purchase is better informed than 95% or so of all ETF investors.

Source:
The Institutional ETF Toolbox: How Institutions Can Understand and Utilize the Fast-Growing World of ETFs

Further Reading:
The Passive Investing Revolution That’s Not So Passive

Full disclosure: Eric interviewed me for this book and I have a handful of quotes sprinkled throughout. I really liked the format of the book because he used quotes from a wide range of investment professionals to understand how they think about and use ETFs, especially from an institutional perspective. More on this in a future post.