How to choose the right ETF?
ETFs do provide safety, diversification and an enviable track record. However, besides cost and diversification, investors have to be careful as to exactly what asset classes and strategies the ETF represents
One of the world’s most celebrated investors doesn't seem all that optimistic about the long-term prospects for his own fund. It was recently revealed that Warren Buffett’s estate plan recommends that 90% of his wealth should be invested in the Vanguard 500 Index Fund, an exchange-traded fund (ETF). What does he know that we don’t?
The reality is that it is exceptionally difficult for anyone to beat an index. Out of the 7,630 funds which have been around for at least 10 years, only 24% of the fund managers outperformed the benchmark indexes. The average management fee for an actively managed fund is between 0.5% and 1%. Which means that even before a single penny is invested, you rack up a loss of upto 1%. ETF fees on the other hand range from 0.14% for the Vanguard fund to 0.6% for some of the others.
Hedge funds are an even more extravagant affair. They charge a 2% fee for funds under management and 20% of any profits. Unlike ETFs some Hedge funds may not be very liquid and can have lengthy lock up periods when you can’t access your funds. For all their fees, hedge fund managers have not done much better than their regular fund manger counterparts. In the past year, hedge funds have risen about 8% before fees and after accounting for their fees have delivered a paltry 4.4% return(on an average?) In the same period the S&P 500 has gained 16%. A simple ETF like the Vanguard 500 Index Fund would have delivered four times higher returns than a hedge fund. In the 2007 to 2009 bear market, hedge funds lost 12% compared to the S&P's 39% drop, which may offer some solace to investors in hedge funds.
Assuming you want to invest in an ETF, how do you choose one? For example, you may want to buy into the financial services sector which you see as being undervalued but want the diversification and safety of an ETF. There are over 45 different ETFs for the financial sector alone. Some own as few as 20 companies, others include the shares of as many as 500. There are 50 different choices for large-cap ETFs. The ETF with the lowest diversification owns shares in 20 companies. The most diversified ETF has a basket of 1,400 shares.
Besides cost and diversification, investors have to be careful as to exactly what the ETF represents. ETFs are created out of thin air. They represent all sorts of different asset classes and strategies. There are ETFs for lithium mining companies, European covered bonds and Frontier markets. But often these ETF products, like other products, fail to generate sufficient interest. If they do not attract enough investors, they may be easy to buy into, but difficult to exit. A few orders can also change the price one way or another. It is important to be sure that the ETF has a large market cap and good trading volumes.
You also have to be careful that you know how long the ETF has been around and its sponsor. Does the ETF have a track record dating back to at least 2007? You need to know how it reacts in both good times and bad.
There are some serious problems with ETFs for certain asset classes. For example, since the taper tantrum, average weekly volume of high yield and investment grade bonds has fallen 6%. However trading volume in high-yield ETFs has risen 18%. It appears that traders are using ETFs to make up for the lack of liquidity in the underlying assets. This is fine until the market comes under stress when the investor would suffer greater losses or be unable to exchange their shares for cash. In contrast, if you owned the underlying bond, barring default, the investor will eventually get the money back with interest. Fixed income ETFs fluctuate with true market value of the market.
Choosing the right ETF provides low cost safety and diversification, but it also chooses an investment strategy. Obviously, if you buy an emerging market, China or Indian ETF, you are betting that these economies will grow faster than the S&P 500.
ETFs are pegged to indexes and how the index is structured will also determine your strategy. For example, buying an ETF that tracks the S&P 500 is a large cap momentum strategy, because the greater a company’s capitalization the more of the index it makes up. Fortunately you can easily solve this problem.
There are many ways to create a stock index. You can weigh the index by dividend payouts, total sales, net book value, annual cash flow or revenue. Over time these ETFs have not only tracked the more recognized indexes, but have also out performed them.
ETFs are one financial innovation that have truly helped the retail investor and as it may now seem, the Oracle of Omaha himself. They provide safety, diversification and an enviable track record. This does not discharge the investor from doing their homework and considering all the advantages and disadvantages, and strategy of an individual product.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
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