20 things to consider when judging an ETF

avatar By: IS
Date posted: 12.07.2010 (5:00 am) | Write a Comment  (8 Comments)

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Last week I did a review of the top 20 things that I look at when judging dividend stocks and it turned out to be a very popular post. It is also a useful one that I can refer to when I get questions about my picks or how I actually judge the stocks. I ended up getting a request to do the same thing for dividend stocks. Of course, it is very different but I started looking at the different factors and it came up to 20 as well! Here they are:

Issuer

-History, reputation: I think it’s important to consider the issuer. In general, ETF’s are products that you can trust but obviously that trust is even more present when you are dealing with issuers like Ishares, which is owned by Blackrock, the largest asset manager in the world. The company has experience in delivering good products that have met expectations and is also considered a trustworthy company. Some smaller issuers are not as known and ideally you can avoid those at the start.
-Other etf’s: In most cases, you have several alternatives when selecting an ETF. If you are looking for an ETF that tracks the S&P500, small caps or financial stocks, you will have alternatives on each of them. Depending on your current portfolio and the exact ETF’s, you should always look for alternatives before making your choice. You could find one that has a similar objective but has less fees for example.

ETF fundamentals

-Index: In general, ETF’s have the objective of tracking an index. It’s not always the case but I have a preference for those that do. Commodity based ETF’s often track a custom made index and that is also good but I’m a bigger fan on index tracking ETF’s. Why? It gives the manager a systematic approach, less turnover and thus you know exactly what you are buying. I have supported some non-index tracking ETF’s such as ELD but in general I’m a fan of index based ETF’s.
-Tracking error : When an ETF tracks an index, you can generally get from the issuer itself a review of past performance. Specially, I’m looking at the tracking error because it gives a better idea of how closely the ETF is linked to the index. If you are buying a specific exposure, you want to be sure that the ETF will track that exposure as well as possible. What’s the point otherwise?
-Derivatives: Many of the newer kind of ETF are based off of derivative trades. Those often track their index more carefully but they also contain other types of risk such as counterparty risk. This information will be clearly disclosed in the prospectus of the ETF as it can make a major difference in how investors perceive the risk involved. Using derivatives has advantages in terms of tax efficiency and accuracy but it also adds some complexity and less transparency.
-ETF of ETF: I have discussed target date funds in the past and why I am reluctant to those. They basically add an additional layer of fees that is rarely if ever useful. I would strongly advise staying away from ETF’s of ETF’s or funds of funds. In general, you can get information about what they have purchased and if you are a long term investor, you will be better off getting the underlying ETF’s.
-MER : Management fees are one of the most important things to look at. They are the fees that you will be charged to own the ETF.  Always compare the MER charged to what is charged by similar funds that have the same or a similar exposure. Obviously, an ETF like EEM which invests in emerging markets will charge more fees than a US only ETF. But you might find a similar cheaper solution such as VWO.
-Other costs : As I had discussed in the past, many ETF’s add “additional fees” not included in the management fees. These can fluctuate a lot but it’s important to take a look in the prospectus as to what such fees should include. I would generally stay away from a fund that has too many of these fees.
-Dividend yield : As you must know by now, we are big fans of passive income portfolios and dividends can be a very big portion of that income. Thus, when looking at ETF’s, it’s always very good to consider the current and past dividend yield. It will give you a good idea of what type of holdings the fund has.
-Number of holdings:  It’s not always better to have more holdings in an ETF. I think it’s important to consider the number of holdings because in some cases, the number could be smaller. In most indexes, a few securities make up the large portion of the return and having less stocks can significantly reduce the costs for the fund.
-Past performance: It’s always a good idea to look at past performance for an ETF. Obviously, you always should bring it back into context. That means that a 5% return when the market returned 20% might not be that good but if the ETF returned 5% in a negative return environment, it might ve a very good sign.

Industry

-Competing ETF’s (volume, fees, etc): When you have an ETF in mind, always take the time to compare it with competing ETF’s. You are looking at the performance, at the trading volume, at fees charged (both MER and other fees) as well as any other factor. This choice is very important at all times but even more so when you are investing for longer periods of time.

ETF

-Inception date: I only consider ETF’s that have been trading for at least 1 year, simply to avoid bad surprises.
-trend analysis: Once I have chosen the ETF, I will often use trend analysis to help me determine the good time to enter the trade.
-Volume: You should always aim for  high volume ETF’s as this will help you be able to sell back you position without paying an additional cost for it. How much? I would say you want to see volume of at least 10,000 shares/day.
- Market cap : The bigger the market cap, the better the chances to see the ETF remain active in the long run. As well, fees are more likely to diminish (or to not increase) if assets increase as costs will spread among more unit holders.
-Spreads: Before investing, check a few times at the bid and ask of the ETF. Is the spread (ask-bid) more than $0.01 or $0.02? If so, you are not getting involved into the best scenario as the price you will pay is probably more than what it is worth and you will be selling at less than fair value. That is also generally a sign that the underlying of the ETF is illiquid. Not a great sign.
-Close vs Nav: Another test that you can do is comparing the close of the ETF on a few days with its NAV (net asset value) which is published on the issuer website. If both are the same or very similar, it’s a good sign.

Fit within portfolio

-Passive or active portfolio?: As I’ve discussed in the past, I’m a big believer in buckets. You would have one passive income portfolio that might be an ETF portfolio or a dividend portfolio. If you are buying an ETF for that portfolio, you are sticking to broad ones with little fees, do not try to get too sophisticated. That means you would be looking for broad stock exposure at home (S&P500), foreign stocks (VWO) fixed income, and a few other categories but buying an ETF that tracks Vietnamese stocks is probably not right for this strategy. If however you are investing in a more active & aggressive bucket, then you have a large universe of possibilities. You must know if the ETF fits the overall portfolio/bucket strategy.
-Issuer diversification: This is another thing I’ve discussed in the past, I think it’s important to have some issuer diversification (i.e. Do not own all of your holdings in Shares or Vanguard ETF’s.

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8 Comments

  1. Comment by Sustainable PF — December 7, 2010 @ 7:40 am
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    Great tips on ETF evaluation. Thanks. I’ll add this to my compilation of investing advice for sure!

  2. Comment by IS — December 7, 2010 @ 8:21 am
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    @SustainablePF – Thanks for the good words!

  3. Comment by OneDay — December 7, 2010 @ 8:28 am
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    A big WOW for me!! I will definitely check this article when investing in an ETF!

  4. Comment by John — December 7, 2010 @ 8:39 am
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    It’s a really great post! Do you also check P/E ratio? Do you think that weighting methodologies that applies to market indexes change something in your investment process? Also, which would you consider as the top three important elements for you to monitor? Thanks!

  5. Comment by IS — December 8, 2010 @ 5:48 am
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    @OneDay – Many thanks!

    @John – P/E is not easy to get for indexes so the information is not always available. Ishares does give out such info usually but not all providers do.

    Top 3 for me would be:

    -Tracked index
    -MER
    -Volume

  6. avatar

    [...] Intelligent Speculator lists no less than twenty things to consider when evaluating an exchange-traded [...]

  7. Comment by ETF Trading Signals — December 19, 2010 @ 12:27 am
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    One of the biggest contributions ETFs have made over the decade is lower fees (when compared to mutual funds). This single contribution has a dramatic effect on portfolio value over the long run for buy and hold indexers.

  8. avatar

    [...] Speculator presents 20 things to consider when judging an ETF posted at Intelligent Speculator, saying, “What to look at before deciding on an [...]

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