Are Your ETFs Lying To You?

by: Evan Powers

Summary

As the number of ETFs has exploded over the last decade, the importance of doing comprehensive research to understand an ETF's composition and strategy has dramatically increased.

Despite the highly competitive landscape, fees still vary widely from one ETF to another, even among funds with very similar characteristics.

Furthermore, many funds that look exactly the same on the surface are anything but; holdings can vary widely, as can rebalancing strategies.

Some funds are even fundamentally flawed at their core, and should be used only as extremely short-term trading vehicles, not long-term investments.

Over the last twenty years, exchange-traded funds (or ETFs) have gradually come to dominate the investing environment, steadily eating into the massive market share held by their older mutual fund cousins. The growth of ETF assets has been matched only by the number of different ETF products - at last check, there were more than 4,600 different ETFs, and the industry continues to introduce hundreds of new funds each year. Unsurprisingly, some people - from investment advisors to industry CEOs - have begun to wonder whether there are now too many products, or at least too few good ones.

Either way, it's clear that ETFs won't be going away anytime soon, and that market participants will need to accept them and learn how to use them wisely. Of course, with so many funds in the landscape, the importance of properly vetting your ETF before you invest has never been greater. Indeed, just relying on the name on the ETF wrapper isn't enough to ensure that your portfolio is getting the exposure you seek. As I mentioned briefly in my recent article on "sustainable" investing, looking "under the hood" to get a good feel for the underlying composition, fee structure, and strategy of the ETF is a vital step for any investor to take before adding a product to an investment portfolio.

I'll take some time to look at some of the most important factors to consider, and how to avoid being lied to by your ETFs.

Check the fees

Unlike their mutual fund counterparts, most ETFs tend toward a passive investing approach, rather than pure active management. Usually, this means some version of indexing, meaning there is little to no room for manager discretion. Since a passive indexing strategy is essentially a Ron Popeil-esque "set it and forget it" approach, there's usually no justification for paying a hefty management fee, since just about any fund manager can replicate the performance of a static index with minimal effort.

But that fact certainly doesn't keep many investment firms from trying, as many ETFs still manage to charge elevated fees for minimal added value. For an example of how widely fees can vary for what appear (at least at first glance) to be similar products, I'll consult the Energy sector, which has a particularly rich set of potential ETF options.

ETFdb.com lists a total of 28 available ETFs in the category, many of which boast more than a billion dollars in total assets (XLE, State Street's SPDR offering, is far and away the category leader with over $14 billion). Among the 28, though, there is almost no agreement on an appropriate level for an expense ratio.

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Based on the data presented, there doesn't really seem to be much rhyme or reason behind the differences in fees. Yes, the two market share leaders (VDE and XLE) are among the cheapest funds, likely owing to some combination of competitive dynamics and economies of scale. But the cheapest of the bunch is Fidelity's FENY offering, which is one of the smallest funds on the board (note that it's also a relatively new fund, which could help explain its lack of scale; the fund launched in 2013, whereas VDE and XLE both have over a decade behind them).

It also doesn't seem to be a passive versus active phenomenon; Blackrock's IYE offering is one of the more expensive funds at 0.45%, but the fund's prospectus makes it clear that it, like the less expensive market leaders, utilizes an indexing strategy.

While a fractional difference in annual expense ratios might not seem like a big deal, fee drags most definitely add up over time, and the compounded effect can have a significant impact on long-term returns for the investor.

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Over a 30-year time horizon, the difference between a 0.25% fee and a 1.00% fee can amount to a cumulative drag of nearly 25% of the overall investment return. Even the difference between a 0.25% fee and a 0.50% fee can amount to a 7% cumulative difference over a working life, which is no small potatoes.

With expense ratios now being widely available through services like Morningstar and others, there's no excuse not to at least know what fees you're paying in your ETFs. Whether you think those fees are justified is another matter, and will largely have to deal with the funds' composition and strategy.

Check the composition

That brings us to our next point. As you'll see from the above table of Energy sector ETFs, not all funds are created equal; a quick glance at the YTD performance for the various funds gives a clear indication that they are not investing in the same types of companies. Clearly, just relying on the "Energy sector" title of the fund is not sufficient research to understand what your ETF is actually doing for you.

Comparing two selected Energy sector ETFs with almost identical names (XOP and IEO), we can see a great demonstration of how composition can differ greatly, even among funds whose titles are essentially indistinguishable.

Both funds are described very simply as "Oil & Gas Exploration & Production" ETFs, but their composition could not be more different. State Street's SPDR offering, XOP, is a heavily diversified and balanced fund, with no holding commanding more than about 2% of its assets. As a result, the top 10 holdings comprise only 21% of the ETF's composition.

BlackRock's iShares offering, IEO, on the other hand, is the polar opposite. IEO's top two holdings alone amount to more than 20% of the fund, and the top 10 holdings have a dominant weight in the fund, at nearly 60%. Furthermore, there is minimal overlap between the top 10 holdings of the two funds, despite their identical titles - only three of the 10 holdings (Apache (NYSE:APA), Marathon Petroleum Corp. (NYSE:MPC), and Devon Energy Corp. (NYSE:DVN)) are shared between the two funds, and none of them are top-three holdings in either ETF.

Given that the wrappers are so similar, it's frankly shocking to see such divergence between the funds' composition; without peeking under the hood, you'd have no idea which companies you owned or in what proportions. Not surprisingly, the two funds have very little correlation with each other, as their YTD performance displays (a longer-term horizon is even more dramatic: over the last five years, XOP has declined by 43.4%, while IEO has lost just 21.5%).

The size of the ETF in question can also play into the "composition" conversation; even a well-composed fund (or at least, one that aligns with your intended strategy) can become disjointed from the underlying value of the assets if the fund is not large enough to support a liquid market for its shares. In general, the larger the fund, the closer the ETF's price will hew to its net asset value (NAV), but there are always exceptions to that rule.

Knowing and understanding the investments that your ETF holds is a vital step in determining whether it is an appropriate fit for your portfolio. With ETFs, like good books, you can't judge the fund by its cover; in-depth research is essential.

Check the strategy

But even if you've selected a fund with reasonable fees and a desirable composition, that doesn't necessarily mean your job is done. ETF investing requires near-constant attention, and an understanding that compositions of ETFs can, and do, change over time - compositions are not static for all funds. That's because each fund will have a different strategy as far as when (or how) to rebalance, or when and how to add or subtract holdings from the fund. No two strategies are exactly alike, and differing strategies can cause two funds that start out looking the same to diverge significantly over time.

One case that bears mention is that of the wildly popular Nasdaq 100 tracking ETF (now known simply as the "PowerShares QQQ Trust ETF (NASDAQ:QQQ)). Twice in the history of QQQ, the fund has had to make a decision regarding rebalancing because one stock had come to have too significant a weight in the index (this happened first with Microsoft (NASDAQ:MSFT) and then with Apple (NASDAQ:AAPL), both of which appreciated so rapidly that they went from being a small component of the index to the largest by far). Because the QQQ is (and was) based around a capitalization-weighted index, there was no built-in mechanism by which to limit the influence of those growing stocks on the fund's composition; their weighting simply grew organically over time, such that what was once a well-diversified index became a highly concentrated one.

More recently, we've seen this same dynamic at play in the SPDR Consumer Discretionary Sector ETF (NYSEARCA:XLY), which has seen Amazon.com (NASDAQ:AMZN) grow to dominate the fund, with a current weighting of 12.6% due to the stock's surge from below $200 per share five years ago to well above $700 today. That's what we mean when we say that composition is not static for all ETFs.

Some funds also have a changing composition by their very nature; ETFs that use futures or options as part of their strategy will frequently have to "roll" their holdings in order to replace expiring contracts. This is also the case with bond ETFs, when their bond holdings reach maturity and the principal amounts are repaid (and need to be reinvested).

In the case of derivatives-based ETFs, the "roll" factor can have a dramatic impact on the fund's performance or its ability to actually track its underlying index. Without getting too deep into the weeds, the term structure of futures prices (or options prices, or interest rates) can introduce a significant price drag in one direction or another, depending on whether the derivatives contracts in question are in backwardation or contango.

At times, this price drag can introduce a fundamental flaw into the ETF construction, as has been the case with most volatility-based ETFs (which have been described as "doomed to march to zero"). Given those flaws, these ETFs are appropriate only as extremely short-term trading vehicles; they have no place in a long-term "buy and hold" portfolio, since they are almost guaranteed to lose money over the long term. Without adequate research, though, an uninformed investor might unwittingly choose to hold an ETF in their portfolio that has no business being there.

The good news for investors is that information on these funds has never been more readily available. A few clicks and a Google search can turn up a fund's prospectus, top holdings, expense ratios, and more. If you know where to look, ETFs can (and should) play a very valuable and important role in your investing strategy. Indeed, that's why so many investment advisors have embraced them in such great numbers, helping to spur the rapid growth in the industry. But as with most investments, if you don't know where to look, you could end up getting clipped in a hurry. Those bad outcomes can, and should, be avoided, no matter how many new ETFs are introduced.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.