For example, two options for tracking small cap stocks are the iShares S&P Small Cap 600 index fund (IJR) and the iShares Russell 2000 index fund (IWM). Both are from ETF-giant Barclays, both have an expense ratio of 20bp, and both have three-star ratings from Morningstar™.
So now what? If I told you that one of those indexes was trading at 17.0x estimated earnings per share (EPS) this year, and the other was trading at 21.3x, wouldn’t that knowledge perhaps make a difference? If you were concerned about a slowing economy and wanted to position your portfolio for the next downturn and I could tell you that during the last recession profit margins for both indices declined but that for one of them profit margins declined much worse—and in fact turned negative—wouldn’t that information affect your investment planning?
To be sure, there is no guarantee that current expectations about fundamentals will prove to be accurate—or even if they are that the market will care in the near term. But over the long term, most investors believe that fundamentals such as earnings and valuations are what drive the stock market. That is why most people, before buying stock in, say, General Electric—which after all is really a collection of business not entirely different from an ETF—would make an effort to compare GE’s fundamentals to that of other industrial companies, and to the market in general.
This brings me to another point, which many would consider so heretical that if I said it at a fund industry conference I’d be laughed out of the room. But humor me for a moment if you would. Mutual fund investors have been indoctrinated with the belief that fees only rob you of performance, and should be avoided or minimized to the extent possible. For mutual funds that’s probably true since few active managers are able to consistently outperform their benchmarks anyway. But for ETFs fees are largely irrelevant.
Now before you stop reading, all else being equal fees do matter. But rarely if ever is all else equal. Fees for ETFs have already been reduced to such an extent that the difference of a few basis points between funds is likely to be overwhelmed by the difference in performance, making fees a secondary and far less important consideration.
Consider, for example, that among several large cap domestic stock ETFs last year, the S&P 500 SPDR (SPY), with an annual fee of 10 basis points, returned 15.8%, while the Dow Industrials DIAMONDS (DIA), with an annual fee of 18 basis points, returned 18.9%. The large-cap iShares Russell 1000 (IWB), at 15 basis points, was up 15.4% and the NASDAQ-100 Tracking stock (QQQQ), at 20 basis points, gained only 7.1%.
Between all those large-cap domestic stock funds there is a spread of no more than 10 basis points in fees, yet a difference in performance of 11.8 percentage points. And don’t assume that the difference will even out in the long term: over the past five years, the spread in cumulative performance is 23.4 percentage points! Who really believes that, five years from now, the performance of each of these funds will be within 0.5 percentage points of each other? That’s the difference that 10 basis points in fees compounded over five years would make.
You’d find similar divergence in returns if you examine small caps ETFs, ETFs within a certain geographic category, or even ETFs from the same fund company both targeting Growth stocks! For ETFs, fees often amount to a rounding error.
Rather, each of the funds mentioned above, despite targeting the same category, have notably different profiles in terms of sector balance, expected earnings growth, historical profitability of constituent firms, and valuation measures such as the price-to-earnings ratio. It is these differences, not fees or past performance, that are likely to determine by and large how the funds will fare in the future.
That is why AltaVista employs a fundamentally different approach to ETFs. Our ETF Research Center provides fundamental analysis of ETFs so that investors can make more informed decisions about which funds are right for them. This approach is intuitive, forward-looking, and, we think, a lot more relevant than past performance and fees.
To be certain, some of the lessons about investing in mutual funds also apply to ETFs. You need to consider your portfolio as a whole, making sure that the funds you select aren’t just highly rated but also suitably diversified and reasonably uncorrelated. For that task, portfolio construction tools are widely available. But whatever the similarities between mutual funds and ETFs as investment vehicles within a portfolio, when it comes to evaluating an individual ETF, the warmed over mutual fund approach just doesn’t cut it.