The widespread adoption of exchange-traded funds has allowed everyday investors to become successful investors. These innovative tools achieve this task by reducing costs, increasing diversification, enhancing transparency, and mitigating taxes, just to name a few.
Yet, as an investment advisor, I am still witnessing many investors analyze these vehicles through a backwards lens. They randomly prioritize features or portray risks based on a hodge-podge of investment criteria. This creates a breakdown in the framework to build a cohesive portfolio.
The following are common mistakes to avoid when selecting and sizing ETFs:
Fund Company Tunnel Vision
This is a holdover from the old mutual fund days when investors had their money with Vanguard, Fidelity, Putnam, or T. Rowe Price. You rarely saw anyone who opened accounts at varying fund companies because it was a huge hassle to manage.
ETFs are wonderful because you can buy just about any of the 2,100 choices from a basic brokerage account. This opens a wide array of choices that allows you to pair multiple fund companies, indexes, or investment styles under the same roof.
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For instance, Vanguard has done a fantastic job of prioritizing costs and rigid index construction in their practice. It’s in their DNA and has allowed the company to become a fantastic success story. Nevertheless, they don’t run the cheapest ETF in every category. Several funds from BlackRock (iShares), Charles Schwab, State Street (SPDR), and others offer similar funds with lower expenses and comparable indexes.
A comprehensive analysis should compare the index construction criteria, total fund cost (including transaction fees and expense ratio), along with performance and other metrics. It may be that Vanguard makes up the core of your portfolio, but you are better off substituting other ETFs in satellite roles to build the portfolio that works best for you.
There are some great ETFs from smaller, independent issuers that are tackling intriguing investment paradigms as well. Don’t be afraid to give these funds a second look if they fit the model you are looking to emulate.
2. Prioritizing Cost Over Structure
I’m all for lowering expenses and substituting ETFs for mutual funds or insurance products is one of the easiest ways to realize this potential. Yet, more recently, ETF investors have become overly sensitive to every basis point of embedded fees. They often forget that index construction criteria and overall asset allocation will have a far bigger real-world impact on your returns than anything else.
When comparing similar ETFs, it’s important to understand how the fund selects, weights, reconstitutes, and rebalances its components. This will allow you to understand how the top 10 holdings contribute to overall performance and what factors may influence a change in that priority.
Don’t become so overly conditioned to the hunt for the lowest costs that you lose sight of what you own and why you own it. Choosing a fund with a 0.35% expense ratio that you can stick with through any market may ultimately be a better choice than a fund with a 0.05% expense ratio that you don’t understand.
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3. Letting One Bad Apple Spoil the Bunch
There is always going to be that one ETF in the news that has blown it for the industry. Maybe it was the result of a shock in the market or an index that failed to perform as its back-test intended. It’s usually because of an innate red flag such as leverage, exotic derivatives, or some other esoteric factor.
Whatever the case may be, it’s important to remember that 90% or more of ETFs are doing right by their shareholders. The funds that bring negative press have done so because they have taken asymmetric risks to try and achieve an unreasonable outcome. Don’t let that deter you from understanding and owning these tools.
You are going to be far better off sticking with funds that are transparent, easy to understand, and with proven track records of success. If you are just starting out on the track of finding your first ETF, these tips may help.
This article has been republished with permission from FMD Capital.