January 25th, 2011
Rachel from Roxborough, PA:
How should I select an ETF for my portfolio?
Good question! ETFs can be wonderful instruments for your portfolio, but not all of them are created equally! As always, we recommend considering your entire portfolio goals, risk tolerance, and exposure when making investment selections. Investing in a variety of asset classes, industries, and geographic exposure (in the right proportions) can improve diversification and maintain appropriate risk levels. Here are some general features to consider when evaluating an ETF to determine if it’s a good choice for you.
Transparency – Make sure the ETF discloses their holdings. You always want to understand what you own (inside of your ETFs).
Liquidity – Look at the average volume of shares traded as well we the bid/offer spread. You want to make sure that you can comfortably buy AND sell the size that you need without significant expense (moving the market).
Expense Ratio – There are often alternative ETFs with very different cost structures. All else equal, seek the more cost effective ETF.
Commissions – Some brokerage firms offer commission waivers on certain ETFs. There can be holding restrictions for these positions. Be sure to consider your broker’s arrangement and factor accordingly.
Data History – If there isn’t sufficient data history (because the ETF is brand new), you may not have confidence in how well an ETF tracks its index or the level of turnover you should expect.
Concentration – ETFs are often selected in part for their wonderful diversification. Some ETFs may contain some very large positions. Just be aware of this and make sure that it is what you desire.
Leverage – Be sure to understand the types of derivatives generally used to create leverage within an ETF. If this is not explicitly what you seek, look elsewhere.
Inversion – Some ETFs are designed to track the OPPOSITE performance of an index. These are often managed logarithmically, and need constant adjustment to maintain the desired exposure. If you don’t thoroughly understand how it works, avoid it! (We do understand how they work…..and still avoid them!)
As an example of differences in liquidity, take a look at the pictures below. You will see “Bid” and “Ask” in box in the upper left hand corner of the page. In the first one, VGK, you can see that the difference between the price you can sell (Bid) and the price where you can buy (Ask) are very close. Compare that to the second picture for FEU. You can see that the Bid and Ask prices are much wider for this security. These ETFs are very similar in type, but VGK has much better liquidity, decreasing the transactional costs.
Even for two ETFs which are purported to be similar by company description, we may not have a full appreciation for the differences if one or both do not disclose all of the underlying holdings. In the case of AGG and BND, the difference is that AGG shows the current holdings, while BND does not. We believe this difference makes AGG more attractive specifically because it is more Transparent. Take a look at the picture below and you will see an example of an updated holdings report. This page is not available for BND.
An example of a difference in Expense Ratio is EEM and VWO. Both of these funds track the same index and, in theory, should have almost identical returns. But as you can see in the pictures below, they have very different Management Fees. EEM charges 0.75% per year while VWO charger 0.27% per year for the same holdings!!! We believe this is a significant contributing factor of VWOs success in growing investor assets at a much faster rate than EEM in the past year.
EEM Fees & Expenses
VWO Fees & Expenses
The last example to look at is concentration. The S&P 500 Index and the NASDAQ Top 100 Index are both very widely recognized indexes. Both are quoted as barometers for how the market has performed over any period of time. But investing in one of these indexes through an ETF will subject you to different levels of concentration. As you can see in the pictures below, the largest holding in the S&P 500 is Exxon Mobil at 3.35%. The largest holding in the Nasdaq Top 100 is Apple at 20%! This means that by investing in QQQQ (the Nasdaq Top 100 ETF), 20% of the price movement of the ETF is dependent of the performance of Apple’s stock. Not that it is a bad investment, but it is something to be aware of when choosing an ETF.
Some resources to aid in your research.
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
Please send us your questions!! If we don’t know the answers, we’ll find someone who does!
If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.