Well-established fund providers sit on suites of exchange traded funds (ETFs) that are popular and relatively well-known in the ETF biz. But other fund providers are stepping into the ETF game, with offerings that are similar to established products. Now that there is a wider selection of ETFs available, it’s up to you to wade through them all to find the ones that are the best fit.
Aside from the obvious things, such as trading volume, assets under management and various weightings, there are some finer things to consider when making the decision about which ETF is right for your clients.
ETF Construction: Same But Different
Most ETFs are constructed in a passive style, which leads most people to assume that a fund’s investment objective should generate returns similar to other funds that track a similar underlying index.
How a fund provider constructs an ETF determines performance, at least in part. ETFs that are based on similar themes may have different holdings. One ETF may limit the number of stocks in the interest of higher liquidity, while another may have the liquidity necessary for larger holdings.
Traditionally, ETFs track a chosen underlying benchmark index and try to reflect the market capitalization weighting within the benchmark. While most are still passively managed, ETFs also use weighting systems other than market cap such as revenue, dividends, or earnings in a portfolio’s make-up, which helps them beat a market-weighted index.
For example, a fund provider may offer funds that each passively track an index but rebalance once a year based on revenue weight. The funds would hold the same stocks as their benchmarks but in varying concentrations as dependent on how low a stock’s price-to-sales ratio is.
Another ETF provider could offer a fund that rebalances according to dividend weighting – the rebalancing process lowers the valuation multiple on the basket of stocks in the ETF. The ETFs raise their overall dividend yield by reducing holdings of stocks whose prices have risen relative to dividend streams.
Some ETFs that cover the same segment of the market may also track different indexes. This isn’t much of a problem for large-caps, since the indexes aren’t that different, but for narrow or niche markets, benchmarks are increasingly important. A market capitalization-weighted index is usually less volatile. A fundamentally based index tends to lean toward value stocks. An equal-weighted index will usually have more small- and mid-cap stocks.
You can find methodology information by visiting the ETF Resume page for any ETF and clicking the prospectus tab.
Costs
There are several types of costs for investors. There’s the ETF expense ratio, commissions and, in certain funds, taxes.
ETF expense ratios may also vary from fund to fund. The average is around 0.50%, but some ETFs cost much more (and sometimes much less) than this, so it’s necessary to do a little digging. You can sort ETFs by expense ratio in the ETF Analyzer to see where the deals lie.
As a result of increased competition for the business of ETF traders, many brokerages have cut commissions and in some cases, made them entirely free. Vanguard and Charles Schwab are among the custodians doing this; check with yours to see if there are any deals and do some cost comparison.
Certain ETFs also have taxes attached. For example, commodity ETFs that hold futures are partnerships, which spread the costs across all investors in a given fund in the form of a K-1. Physically-backed commodity ETFs can be taxed as collectibles, which is 28% right now. There are also capital gains, which for ETFs are rare, but they do happen.
Knowing the ins and outs of costs can save you money and heartache later.
Large and Established
The larger ETFs, or those with greater assets under management, provide investors the safety of liquidity and tighter bid/ask prices. Furthermore, these funds also have higher average transaction volumes, which provide some protection against major swings in the fund’s prices as a result of institutional investments.
In the world of ETFs, most funds cover specific indexes, including large-caps, mid-caps, small-caps, growth or value indexes. Other funds focus on specific sectors, countries or regions. ETFs that invest in large-caps are generally the most liquid. Equities and fixed-income ETFs tend to be the most liquid of all asset classes.
Underlying securities that trade on large, well-known exchanges are also more liquid than those trading on smaller exchanges. ETFs that reflect those securities would also be more liquid.
Low-risk securities tend to be more highly traded, and as a result, ETFs that cover these securities would also have higher trading volumes and greater liquidity. Investors trading in ETFs with lower average trading volumes may be subject to higher bid-ask spreads, whereas institutional investors would likely trade in creation units.
By keeping these points in mind, you might find it easier to make a decision when you’re navigating the ETF universe.