One would think, on the surface, that ETFs would be much easier to analyze than stocks. For starters they have offer the diversification of many securities pooled into one vehicle. This should lower trading costs – if those are still an issue. In The Little Book of Common Sense Investing, Jack Bogle goes into detail about index investing and its positive impact on investing and by default, society. How could one go wrong? To say that there is no risk inherent in the rapidly-growing structure would be irresponsible.
The dynamics of creating and redeeming an Exchange Traded Fund have been discussed at length, albeit contentiously. That result, be it positive or negative, we may find out on another day. Where the risk lies, from our view, is in the concentration of positioning. If you think about it from a disconnected point of view, an index fund follows an index. An index is made up of stocks; the important ones are generally market capitalization weighted, such as the S&P 500. So when one buys a share of this fund, they are essentially giving a larger portion of money to the largest market cap companies- whether they deserve the overweight or not.
The slippery slope argument would lead us down a path where indexing gets so popular that active management is unable to arbitrage intrinsic value discrepancies and crowd mentality would perpetuate in perpetuity. This is a stretch, but a variant of this kind is not unreasonable.
Now, on to a less prophetic analysis.
Fees have been proven to eat away at returns on a broad scale. Sure, some talented or niche managers can create funds that consistently outperform, but unless you can find them, you’ll be paying for average.
Liquidity is also a factor despite the ability to create and destroy share daily. Large spreads vs. peer funds indicate that you may not be able to trade at an opportune price when you would like.
Tracking Error is a measure of how well a fund tracks its stated benchmark. One that is lacking in this ability may sit at a discount or premium to net asset value at the market’s close. While this is hard to find for free, etf.com has an analysis tab on its screener which grades benchmark “fit”. It is the column labelled “F”.
Security ownership vs. derivative exposure is important if you want low tracking error and less counterparty risk. If a fund that tracks the S&P owns the stocks you can rest assured you’ll get a similar return. If they own derivatives there is still a good chance it will mirror, but it comes with risks in times of stress.
The Stated Benchmark is important because, despite a fund’s name, it may not be exactly what you expected. MSCI and FTSE are both prominent index providers, but in the emerging markets category MSCI includes South Korea and FTSE doesn’t. That is a 15% difference in makeup.
Leverage is an important factor in your search for an ETF. As a general rule, most investors do not want leverage. It magnifies both gains and losses. Unless you are acutely aware of why you want leverage and the terms at which the funds borrow, it may be best to stay away.
Below is a checklist for ETF comparisons, it is not exhaustive, but it should help prevent common errors: