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ETFs – 4 Considerations Before Buying

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ETFs (Exchange Traded Funds) are the  “hot” investing product. Fund companies are tripping over themselves to bring new ETFs to the market place.  This reminds me a lot of the mid to late 90s and the proliferation of new mutual funds.  While the number of ETFs is lower, the growth in new products is still high.

Traditionally most ETFs have been index products.  The new frontier is actively managed ETFs.  Several providers have filed for approval to offer active ETFs, no doubt buoyed by the success of the ETF version of PIMco’s popular Total Return bond fund (tickers BOND for the ETF and PTTRX for the fund).

I have been a big user of ETFs in the portfolios of my individual clients.  To date I’ve used index ETFs exclusively.  The low cost and style purity are the big selling points in my opinion.

Just as with mutual funds or any other investment vehicle, investors need to do their homework before buying an ETF.  Here are 4 factors to consider:

Understand the ETF’s underlying index

Beware of ETFs with somewhat suspect underlying indexes. According to Chuck Jaffe in a MarketWatch article several months ago, a Vanguard report found that “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.” 

Many of these new ETFs rely on the hypothetical back-testing of these new indexes. While history is not always a good predictor of future performance, I like to see an ETF with an underlying index that has been “battle tested” in the real world.

Even among ETFs tracking more traditional indexes there can be differences.  For example in the Large Cap Growth style:

  • iShares Russell 1000 Growth ETF (IWF) tracks the Russell 1000 Growth Index, the growth slice of the Russell 1000 Index.
  • Vanguard’s Growth ETF (VUG) is in the process of switching index benchmarks as part of an overall switch of benchmark providers by Vanguard across many of its index mutual funds and ETFs.  The new provider’s index will remain a bit different from the Russell index used by the Barclay’s ishares product.
  • The Schwab U.S. Large Growth Index (SCHG) tracks Dow Jones U.S. Large-Cap Growth Total Stock Market Index, with a smaller market cap than the benchmark index of the other two ETFs. Additionally the Schwab ETF has higher weighting in financial stocks than most other Large Growth indexes.

To most investors these are fairly subtle differences, but none the less each of these Large Growth ETFs will exhibit slightly different performance during different market conditions.

Leverage and inverse indexing

Not all ETFs make sense for all investors.  There are a number of ETFs that move inversely with a given benchmark.  For example there are ETFs that move in the opposite direction of the S&P 500 index.  What many investors fail to understand is that these movements are tied to the markets on a daily basis, over longer periods of time the performance may not be as closely tied to the inverse performance of the index due to the use of derivatives in these products.

Leveraged index ETFs are available both long and inverse.  These ETFs multiply the movement of the index both up and down.  This is great if you’ve “bet” in the right direction.  However if for example you hold a leveraged ETF that goes 3 times inverse of the S&P 500 Index during a  market rally the ETF will drop in value roughly 3 times as much as the gains on the S&P 500.

There is nothing wrong with either inverse or leveraged ETFs as long as you understand how they work, when and when not to use them, and are comfortable with the risks.  In my opinion these products are not appropriate for most individual investors.

Know what you are buying 

With the advent of “funky” index products as mentioned above and with the growth of actively managed ETFs, investors really need to understand where they are investing their money more than ever.

ETF providers are just like mutual fund providers (in fact many firms offer both) in that they are about gathering assets and making a profit.  There is nothing wrong with this, but make sure that you invest based upon your needs and unique situation and that you ignore their hype, especially about “new and better” ETFs. 

Cheap is good 

One of the great features about ETFs has generally been their low expense ratios.  Just as with mutual funds and any other investment vehicle the cost of ownership is critical, cheaper is better.

Along these same lines there is an ETF price war going on.  The major players are Vanguard, Barclay’s (via their ishares), and Schwab who is trying to make inroads into the ETF business. It is key to make sure that the ETF product fits your needs and your portfolio, don’t just opt for the lowest expense product.

It is also important to note the transaction fees involved in buying ETFs.  Remember ETFs trade like stocks during the trading day as opposed to mutual funds which trade daily after the market close.  A number of custodians offer no transaction fee trades for certain ETFs.  Look at how you will be investing. Will you make larger lump-sum purchases? If so, paying a transaction fee for an ETF really won’t make much of an impact. However, if you will be making smaller purchases, say via dollar-cost averaging, it pays to look around.

Do you use ETFs?  Please leave a comment about your experiences with ETFs both good or bad.

Please feel free to contact me with your financial planning and investing questions. 

For you do-it-yourselfers, check out Morningstar.com to analyze your ETFs and all of your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.

Photo credit:  Wikipedia

 

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Index Funds: Know What You Are Buying

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The financial press and many financial advisors advocate the use of index mutual funds and ETFs in your portfolio.  I concur.  Index funds offer many advantages:

  • Low costs
  • Style purity
  • In many cases, better performance than a majority of actively managed funds within the same investment style.

In a recent study, Morningstar indicated that one of the key predictors of a fund’s success is low expenses.  I use index mutual funds and ETFs extensively across my practice for the reasons listed above.

That said, like anything else in the investing realm, picking the right index fund takes some work.   Here are a few thoughts to consider as you go forward.

Low expenses are critical.  Let’s take a look at two funds tracking the popular S&P 500 index.

Fund Ticker Cumulative Return Annualized Returns Growth of $10,000
Vanguard 500 Index Inv VFINX 28.84% 2.21% $12,885.29
Principal Large Cap S&P 500 Index A PLSAY 19.01% 1.51% $11,903.55

The above chart, taken from information from Morningstar assumes the investment of $10,000 in each on 12/31/2000 and that the funds were held with all distributions reinvested through 7/31/2012.

While the returns on both funds are anemic, the difference between these two funds which track the same index and should have virtually identical portfolios is their expense ratios.  The Vanguard fund sports an expense ratio of 0.17% while the Principal funds expense ratio is 0.62%.  The difference in dollars accumulated is about 8.3% between the two funds.

What index does the fund track?  

Let’s look at some popular ETFs in the Mid Cap Blend style:

Name Ticker Avg. Market Cap $ millions Index Tracked
ishares Russell Mid Cap Index IWR 6,906 Russell Mid Cap
SPDR S&P 400 Mid Cap MDY 3,354 S&P 400
Vanguard Mid Cap Index VO 6,138 MSCI Mid Cap 450

All three of these ETFs are solid choices but they follow different indexes with somewhat different characteristics.   For example the smaller average market capitalization of the SPDR product means that it will outperform the other two ETFs during periods where smaller stocks lead the market, as happened over the five year period ending July 31.  By contrast during the three year period ending July 31, larger stocks outperformed, and as such the SPDR product trailed the other two ETFs.

Does the index make sense?  Recently Chuck Jaffe wrote an excellent piece on Marketwatch.com entitled “These ETFs get an “F” for fiction” in which he was critical of the proliferation of new index ETFs based on questionable underlying indexes.  Jaffe cites a recent study by Vanguard indicating that there were 1,400 U.S. listed ETFs that tracked about 1,000 different indexes.  The report further concluded that over half of these indexes existed for six months or less prior to the inception of an ETF designed to track it.

What does this mean for you as an investor?  It means that you may be buying into an index product that has only been tested “in the lab” so to speak.  This reminds me of the mid to late 90s when I made a career switch into the financial advisory world.  At that point in time mutual funds were proliferating at the same rate as the Duggar family (of TLC fame).  Many of the new funds made little sense from an investment standpoint and were brought to market to capitalize on the Bull Market of that time period.  Fast forward to today and we are seeing much the same thing with ETFs, the popular investment structure of this day.  Fund companies want to ride the wave here and can’t seem to get new ETFs to market fast enough.

Tom Lydon, editor of ETF Trends is quoted in Jaffe’s article:

“You’ve got about 1,400 ETFs today, and about 95% of the money invested is in the largest 10% of those funds,” Lydon said. “You have plenty of choice, and you’re not really missing out on anything if you don’t buy the newest ETF out there. … If you see some creative new index with an ETF, watch it for awhile. Maybe it turns out to be something you want to own, but you don’t need to take the risk and jump in right away, when they’re saying the strategy is proven but you know it’s really not.”  

Here are a few tips when considering an index mutual fund or ETF:

  • Rule number one, low cost is good.  This is also rule numbers 2-10.  Paying up for an index fund, in my opinion, makes no sense whatsoever.
  • I tend to stick with more mainstream indexes for my clients.  I am an asset allocator and I want to have an understanding of the type of performance that I can expect over various market conditions.  We may not like that results (as in 2008) but they were not unexpected based on market conditions.  With some of these new, back tested only, index products it is hard to tell how they will react under real market conditions.
    • In short, understand the underlying index of the fund and how it fits with your other holdings.
  • Buy right.  By this I mean look at how you will be investing.  Will you make larger lump-sum purchases?  If so paying a transaction fee for an ETF or for a Vanguard fund if investing someplace other than Vanguard (Schwab for example) really won’t make much of an impact.  However, if you will be making smaller purchases, say via dollar cost averaging, it pays to look around.
    • At Vanguard, once you meet their minimums, additional investment amounts are fairly low for their mutual funds.  Additionally you can buy their ETFs with no transaction costs.
    • Fidelity offers a number of ETFs without a transaction fee.
    • Schwab has developed their own series of index ETFs for which there are not transaction fees for Schwab account holders.  I use some of these ETFs for smaller purchases for some clients.
    • As with anything, please check on any restrictions at these or other firms offering similar deals.
  • Many 401(k) plans offer index funds as a choice.  In some larger plans participants may be able to reap the plan’s buying power and have the opportunity to buy ultra low cost institutional index funds.
  • Vanguard is a prime example here, always make sure you are in the lowest cost share class that you are eligible for.

Index funds can be a great choice for your portfolio.  Always fully understand what you are buying and why you are buying it.

Please feel free to contact me with your investment and financial planning questions.

 

Photo credit: nikikl

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