[dropcap]U[/dropcap]sed correctly, ETFs can be very good tools for building some or all of an efficient portfolio. This is true for both stock and bond allocations. Not all ETFs are created equal, however. Like all major purchases, it is worth doing some research before buying. This includes looking at the website of the actual fund. At a minimum, check the top ten holdings and make sure you are comfortable with what you see.
These are some of the major items to consider when selecting ETFs.
A primary reason to use ETFs is cost effectiveness, so it follows that lower cost ETFs are better. This is generally true. The cost is essentially the expense ratio plus the bid/ask spread. Check the fund prospectus to find the actual expense ratio. All else equal, choose the lower cost ETF. However, if a low-cost ETF does not have adequate liquidity, consider using the one that does and switching after a few years if the low-cost choice becomes more popular. Also, don’t choose a benchmark you don’t want just to save 0.1 percent. Fees are very important, but asset allocation is more important.
The bid/ask spread on most commonly traded ETFs is $.01. This has very little impact on long term investors. Check the bid/ask before you buy. If it is more than $.02, factor this into your decision. You can find the bid and ask by entering the ticker into Yahoo! Finance during market hours or by looking on your broker’s website.
The ETF needs to track the index you need, based on your asset allocation decision. Try to avoid price-weighted indices such as the DOW or Nikkei, since they don’t represent the underlying market well. Capitalization weighted indexes – which most are – are better, but have flaws as well. At Personal Capital, one of our core beliefs is that we can perform better than capitalization weighting by blending exposure to different market factors more equally.
We do that for clients by building portfolios of individual stocks. If you are sticking to one ETF for your US stock exposure, try use the broadest ones possible.
We have already covered the bid/ask, and that is the primary liquidity concern, but you should also keep in mind the liquidity of the underlying securities. In normal times this is not an issue, but should another credit crisis arrive, some assets tend to lose liquidity. For example, although there is no such thing, imagine an ETF that tracks the value of fine art. In an economic crisis, there may be no market for fine art, so the market for the ETF would dry up as well.
For broad-based equity indexes, this is not a big concern, but for more narrow or exotic parts of the global equity market it could be. Bonds tend to be much less liquid than stocks, and bond ETFs reflect this. Spreads to NAV in bond ETFs are often meaningful, and you may want to check them before trading. If the ETF is trading at an unusually high premium or discount to NAV, it is often worth waiting for it to narrow if the spread is working against you.
About the Sponsoring Companies
For the most part, it doesn’t matter which company sponsors the ETF, but there are a few subtle differences to be aware of. Try to avoid the really small ones which may not survive and may have to close funds. SSgA and BlackRock are publicly traded asset management companies. They care about profit from management fees. Vanguard has a unique ownership structure where the parent is actually owned by the funds themselves. Schwab, a new player in ETFs, is a public company which is mostly interested in brokerage and asset custody, though they won’t mind making money on management fees either.
[quote style=”boxed”]For the most part, it doesn’t matter which company sponsors the ETF, but there are a few subtle differences to be aware of.[/quote]
You shouldn’t really care about the structure of the parent company or who ultimately gets the profits. You only care about getting a good product at a good price. Luckily for investors, there is enough competition to provide an efficient market which fosters innovation and competitive fees.
Here are some notes about the most important providers.
Vanguard – Founded by John Bogle, Vanguard is credited with creating the first index mutual fund. Vanguard is unique because the company is owned by the funds themselves, sort of like a mutual insurance company. This gets confusing. In theory, this means the goals of the parent company are totally in line with the shareholders of the funds themselves. This is one reason why Vanguard tends to have relatively low fees. Management is not responsible to public shareholders who demand higher and higher profits from fees. In reality, this is true to some extent, but one can’t help notice that the parent company spends a lot of money and effort on expansion, new products, and marketing. As a shareholder of some of their funds, I really couldn’t care less about this effort and would rather that money be used to lower fees on existing funds. Another unique aspect of Vanguard ETFs is that they are technically a separate share class of existing mutual funds. This is totally transparent to the owner of the ETF, but it has some implications. Some people believe this structure limits the tax efficiency of the ETF model. This is because redemptions in the mutual fund will trigger gains that must also be distributed to ETF holders. Actually, because the market has been weak lately, this may turn out to help more than hurt in the next several years. Ultimately, all this shouldn’t mean that much. Stick to using benchmark, cost and liquidity as your main concerns when choosing among ETFs.
SSgA (State Street Global Advisors) – SSgA is a division of State Street, a publicly traded company. Often referred to as SPDRs (spiders), they offer a fairly complete lineup of foreign and domestic stock and bond ETFs, including the most popular of the S&P 500 Index ETFs, SPY. They also sponsor the increasingly popular Gold ETF, GLD.
BlackRock – Controls the iShares brand of ETFs, and is the leader in the industry. The company purchased iShares from Barclays Global Investors for $13.5 billion in 2009. BlackRock is publicly traded and is one of the largest asset management companies in the world, worth about $40 billion at the time of this writing. iShares has a broadly diversified stable of funds in global and domestic stocks and bonds as well as some commodities. It is a good company and has some good products.
Charles Schwab – Schwab is the largest discount brokerage company. They recently introduced their own ETFs. At first glance, they are very price competitive. If you have a Schwab account, you can trade them for no commission, which actually doesn’t matter much. They are gaining meaningful traction but at this point are still too new and don’t have enough liquidity to recommend. Schwab usually does a good job with their initiatives, however, so it is worth keeping an eye on these products.
WisdomTree – Most ETFs track indexes that are capitalization weighted. This means the most valuable companies have proportionally the biggest weights in the index and have more
influence on returns. WisdomTree ETFs track indexes that are weighted by earnings and dividends. They have relatively short track records with mixed results. These ETFs tend to have slightly higher fees than traditional ETFs.