Investing in ETFs combines the flexibility of trading individual stocks with the built-in diversification and low costs of mutual funds. As an exchange-traded fund, you buy shares in an ETF directly from any brokerage account. Net, in one transaction you can buy a bundle of stocks represented by the ETF. You need to Things To Check Before Buying ETFs
However, with more than 1,800 ETFs on the market today, and 150+ launching each year, it can be tough to determine which ETF will work best in your portfolio. How should you evaluate the ever-expanding ETF landscape? Below are the 3 things you have to check before buying any ETF:
- Start with what’s in the ETF
The single most important thing to consider about an ETF is its underlying index. You need to know the top stocks in any ETF you consider buying. We’re conditioned to believe that all indexes are the same. This is not correct. For example, the Dow Jones industrial average holds 30 stocks and looks (and performs) nothing like the S&P 500. One popular China ETF tracks an index that’s 50 percent financials; another tracks an index with no financials at all.
One of the beautiful things about ETFs is that they disclose their holdings (mostly) on a daily basis. So, take the time to look under the hood and see if the holdings, sector and country breakdowns make sense. Do they match the asset allocation you have in mind?
Pay particular attention not just to what stocks or bonds an ETF holds, but how they’re weighted. Some indexes weight their holdings more or less equally, while others allow one or two big names to shoulder the burden. Some aim for broad market exposure, while others take risks in an attempt to outperform the market. Know what you own. Don’t assume that all ETFs are the same, because they definitely aren’t!
- How high is its tracking difference?
Once you’ve found the right index, it’s important to make sure the fund is reasonably priced, well-run and tradable.
Most investors start with a fund’s expense ratio: the lower the better.
But expense ratios aren’t everything. You should look at a fund’s “tracking difference.” ETFs are designed to track indexes. If an index is up 10.25 percent, a fund should be up 10.25 percent too. But that’s rarely the case.
First, expenses create a drag on returns. If you charge 0.25 percent in annual fees, your expected return will be 10.00 percent (10.25% – 0.25% in annual fees). But beyond expenses, some issuers do a better job tracking indexes than others. Also, some indexes are easier to track than others.
Let’s start with the base case. For a popular large-cap U.S. equity index like the S&P 500, most ETFs tracking that fund will use what’s called “full replication.” That means they buy every security in the S&P 500 at the exact ratio at which they are represented in the index. Before transaction costs, this fund should track the index perfectly.
But what if they are tracking an index in Vietnam that has a lot of turnover? Transaction costs can eat away into returns.
Sometimes, fund managers will only buy some—not all—of the stocks or bonds in an index. This is called “sampling,” or more optimistically, “optimization.” A sampled strategy will typically aim to replicate an index, but it may over- or underperform slightly based on what securities it holds.
Other factors can influence tracking as well, including how good the ETF manager is at overseeing cash positions and executing trades, or managing its share-lending book. All in all, the lower the tracking difference is—especially on the downside—the better.
- How liquid is the fund?
If a fund has the right strategy and is well-run, you then decide if you can buy it. The three things you want to look for are the fund’s liquidity; its bid/ask spread; and its tendency to trade in line with its true net asset value.
An ETF’s liquidity stems from two sources: the liquidity of the fund itself; and the liquidity of its underlying shares. Funds with higher average daily trading volumes and more assets under management tend to trade at tighter spreads than funds with less daily trading or lower assets. But even funds with limited trading volume can trade at tight spreads if the underlying securities of the fund are liquid. An ETF that invests in S&P 500 stocks, for example, will probably be more liquid than one that invests in Brazilian small-caps or alternative energy companies. It just makes sense.
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