|Wealth Management Perspectives
Sizing Up Exchange-Traded Funds
Exchange-traded funds are increasingly popular tools
for investors trying to broaden their exposure to global
equities markets. But how do you decide which ETFs
measure up best to suit your goals?
With stock-like trading
characteristics, low costs,
transparency and tax efficiency,
exchange-traded funds (ETFs)
have wooed and won many retail and institutional
fans during the past 15 years.
Now, more than 700 ETFs collectively offer
investors broad industry and geographic coverage.
During the first half of 2008, firms unveiled
approximately 120 new ETFs, according to
mutual fund analysis firm Lipper, while assets in
U.S.-listed ETFs now top $600 billion. Although
that pace has slowed with a more bearish market
environment, the long-term trend of ETF
growth is expected to continue. In fact, the U.S.
Securities and Exchange Commission is currently
implementing a streamlined ETF approval process
to move them into the marketplace faster.
Several retail ETF screening programs are
available to help narrow the field of choices,
but these programs assume you already have
some idea of what type of ETF you need, and
they generally are not customized to address
specific portfolio needs.
So how do you choose? Whether you are a
self-directed, hands-on investor, or you largely
leave those decisions to your financial advisor, there are some
concepts you should keep in mind. The best overarching tip
is this: Think long-term, think strategic and ask yourself the
following basic questions when evaluating whether an ETF
makes sense for your circumstances and needs.
Does It Fit?
How does this new ETF fit into your overall portfolio?
Is it the best vehicle to accomplish the goal? Find out what
the ETF brings to your portfolio that is new. It might offer
exposure to a new asset category not already in your
portfolio, or maybe it deepens or broadens existing
exposure to a category.
For instance, your international investments might be
built on a core of capitalization-weighted index funds with
regional exposure across the entire non-U.S. equity asset
class. Then you can add a strategic or tactical overweight
in certain individual countries. But if you have exposure
only to developed markets, that’s not the full international
product set. So investing more broadly to include emerging
or even frontier markets might be useful to your overall
portfolio. You may want to use ETFs to accomplish those goals.
Does It Provide Proper Exposure?
Does the ETF provide efficient exposure to a defined asset
category and/or index? Is the index well-known and transparent
in its construction? How accurately does the index reflect the
market it intends to capture? Beware of so-called “label risk”
and check whether the index actually delivers the
exposure that its name leads you to think it does. For
instance, nearly 50% of the first frontier market ETF investments
were in Poland and Chile, which really are standard
emerging markets and not frontier markets. So make sure
that what you see is what you really get — that the ETF
actually delivers the exposure you want in your portfolio.
Novel Idea, Many Choices
The ETF concept is novel yet quite straightforward. An
equities-based ETF wraps together a basket of stocks
tracking a specific index into a single instrument that
trades like a stock on a securities exchange. You can
trade ETFs at intraday prices instead of only at the once daily
net asset value price used by mutual funds. Also,
because most ETFs are index-based investment programs,
they offer a more efficient delivery mechanism and tend
to have lower expense ratios than comparable mutual
funds. In addition, because of the way ETFs are built, they
rarely distribute capital gains, a key benefit for investors
holding them in taxable accounts.
The success of the biggest ETFs has spawned a huge
array of offerings, from plain-vanilla U.S. blue-chip stocks
to wind-powered energy and commodities. There also are
single-market ETFs that enable an investor to target
specific developed- or emerging-market exposure. The
ever-broadening range of ETFs may make it more challenging
to pinpoint which specific ETFs are optimal for
your particular financial needs and goals. But chosen
with careful research and analysis, these vehicles may
serve a valuable role in your portfolio.
Is the Manager Experienced?
Does the ETF sponsor or manager have experience developing
and maintaining index-based products? One benchmark you
can use is whether the manager, even if it is new to the ETF
marketplace, already has assets in that particular category. If
you’re considering international equity index ETFs, find out
whether the manager already has several billions or tens of
billions of dollars under management in that category. In addition
to the amount of assets under management, consider the
manager’s overall breadth of experience.
How Well Has the Manager Performed?
What is the expected “tracking error” of the ETF versus the
index benchmark? A manager may have the experience, but
tracking error provides a useful way to measure the manager’s
performance for that index.
How Liquid Is the ETF?
What is the liquidity of the ETF, both in the secondary market
and in the underlying basket of stocks comprising the ETF?
Liquidity is important because less-liquid markets can make
trading potentially more expensive.
As the industry continues to evolve, interest and investment
in ETFs likely will grow, including in newer iterations based on
frontier markets, fixed income and even actively managed ETFs.
But just because it sounds sexy or tracks a current theme within
the financial industry doesn’t mean a particular ETF is the best
one for your portfolio. Investors will have to be increasingly
diligent about understanding what’s inside these ETFs. And that
makes education and a long-term focus even more crucial.