6 things to look at before buying an ETF

By: ispeculatornew
Date posted: 08.31.2009 (5:00 am) | Write a Comment  (7 Comments)

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Bear marketThis will be to no surprise for any regular readers but we at IntelligentSpeculator are fans of ETF’s, they provide such an easy and transparent to trade the markets. There are of course many reasons to use them but generally, I think they are the most appropriate investments for smaller portfolios. Let’s be honest, ETF’s are the easiest way to have a diversified portfolio that can be re-allocated easily.

Of course, when you have a few million dollars, the fees charged by most ETF’s are a bit expensive. But most of us, unfortunately, do not have millions to invest. So between mutual funds and ETF’s, the choice is very easy. But with that being said, now more than ever, new ETF’s are born every week it seems and they might not be all that great to invest in.

Here are a few criteria’s we believe to be important when looking for a suitable or acceptable ETF:

1-Annual fees

This might be the most obvious point, but it is not as straightforward as you might think. Actually, while ETF’s do generally have very low annual fees, not all of them do. It is important to look at them when considering buying ETF’s for a long term investment. It is difficult to give a number to look for as it really depends on the type of ETF. Generally, ETF’s that invest in US equity markets should have very low fees, of .50% or so. But ETF’s that invest in emerging countries will and should have higher fees. After all, the managers will face higher trading, execution and even legal fees. That is one of the costs of business when dealing in emerging or frontier markets.

2-Liquidity

This is one of the most underestimated criteria’s. While there are new ETF’s every day, some of them have so little liquidity that you will be paying enormous “fees” in bid-ask spreads. Basically, imagine a stock that is worth 10,50$ but you must pay 11$ to buy it and once you sell it, you will get 10$. That would imply a 1$ spread (10$ bid, 11$ ask). You would lose 1$ (almost 10%) on the trade even though you actually made an investment that did not lose any value. Crazy isn’t it? I think it is one of the biggest mistakes made by investors when choosing an ETF.

There are generally two things to look at when considering the liquidity. First off, you want enough size to be available. As a rule of thumb, I like to trade no more than .1% or 1% of the average daily volume. Because if you try to buy a 1000 units of a stock that generally as 10,000 traded, you will have an effect on the price and will end up paying higher.

At the same time, a good way of looking for liquidity is to look at any time during the day at the bid and ask on the ETF. Generally, a very liquid ETF will have a bid -ask close to 0.01$… So a bid 10.49, ask 10,50. It can get a little worse than that but I personally do not really consider stocks that trade at a bid-ask of more than 0,10$, it is simply too illiquid and risky.

3-Underlyings

Generally, you can easily find out what is owned by an ETF and take a look. You will get an idea of what it does etc. It could turn out that you are easily able to replicate the ETF and could end up paying fewer fees.  For example, I had written about target date funds that basically give you a one stop option investment possibility. I had considered investing in it but then noticed it only had about 7 or 8 underlings’. In such a case, especially for a 30 year investment, I will be better off investing in those 7-8 funds myself instead of paying the additional fee to the target date fund manager.

4-Company behind the ETF

Like any other investment, it is worth taking the time to look into the company that is managing the ETF. Is it reliable, profitable? Those are all good questions. I personally like Ishares a lot because they are so huge, have a good reputation and while they have recently been sold, they are still owned by a very reputable company in Blackrock, now the largest fund manager in the world. Picking smaller lesser known companies might give you a slightly better chance of investing in a fraud like those we’ve recently witnessed, unfortunately.

5-Prospectus

Depending on the fund, it can be a good idea to take a look at the prospectus of an ETF. While an ETF that tracks the S&P500 is fairly straight forward, others such as leveraged ETF’s and/or those investing in commodities are subject to many other criteria’s that you might not know before investing. For example, knowing if a fund invests in physical natural gas or in companies that produce the physical gas makes a huge difference and yet many confuse the two.

6-Past performance (vs. index)

It is always good to compare the return of the ETF in the past year or more to the return of what it is tracking. If the S&P500 is up 10% for the year and your ETF is only up 2% or is up 18%, you should investigate. Of course over performing is good, but you have to wonder what caused this as it could result in an underperformance the next time around.

So those are the basic things we personally look at when trying to evaluate an ETF, what about you?

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7 Comments

  1. Comment by Frank — August 31, 2009 @ 7:27 am

    Great post!

  2. Comment by The Financial Blogger — August 31, 2009 @ 2:03 pm

    I’d like to know what is the difference between a ETF and a index mutual funds. Most index funds charge around 0.50% and they have no trading fees. Which one is better?

  3. […] When selecting an ETF, there are basic criteria to look for to have success in your investment. Intelligent Speculator gives us some points to consider when looking at specific ETFs, while we throw in some of our […]

  4. Comment by IS — September 14, 2009 @ 8:25 pm

    @TFB – in theory, they could be equal, however generally mutual funds do charge a bit more and also often have various penalties when you withdraw too quickly. Some US Index ETF’s charge 0,10-0,20% of fees… even that bit of difference can make a significant difference in my opinion

  5. Comment by The Financial Blogger — September 16, 2009 @ 9:29 am

    So comparing Altamira index funds at 0.57% MER with no transaction fees to CDN ETF’s will come to about the same? except you can get more specific (by sector) with ETF’s?

  6. […] closed! You can still take a look at Mike’s post here And also, be sure to read about the 6 things to look at when selecting an ETF. If you liked this article, you might want to sign up for my FULL RSS FEEDS. Then, you […]

  7. […] would say that it is still fairly easy to decide which ETF you should invest in. Simply follow the 6 rules of how to choose an ETF. But the more important issue here is that investors should be happy about having so many […]

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