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The ETF research team at Barchart.com selects the "Best in Class" ETF for various different ETF sectors. Investors can become easily overwhelmed by the many similar ETFs that are offered in ETF sectors such as commodities, energy, mining, infrastructure, etc. Using a variety of... More
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  • How to Select a “Best in Class” ETF

    Exchange-traded funds (ETFs) are very attractive investment vehicles.  However, there are now more than 1,000 ETFs, meaning that an investor can quickly become overwhelmed by trying to find the ETF that best suits his or her investment goals.  Moreover, there are usually multiple ETFs available in each sector, making it difficult and time consuming for an investor to decide which ETF is the best in a particular class. 

    In Barchart.com’s “ETF - Best in Class” series of research reports, our ETF research analysts will analyze and choose the best ETF in a variety of different ETF sectors.  All exchange-traded products are certainly not created equal.  There are many differences between exchange-traded products that make choosing the best ETF a key to investment success.  This article outlines our strategy for the selecting the best ETF to suit one’s investment goals. 

    1.  Choose an investment sector and find a list of ETFs in that sector

    First, consider the investment goals you are trying to meet with an ETF investment.  Are you planning to use ETFs to build a core portfolio of stocks and bonds?  Are you trying to diversify your portfolio beyond stocks and bonds and are therefore looking for other assets classes such as real estate, commodities, or hedge fund strategies?  Or have you already covered your basic portfolio and you are now looking to take a flyer and invest a small portion of your portfolio in investment sectors with higher risk/reward potential? 

    Once you have identified the ETF sector of interest, then you need to find a list of all the ETFs in that sector.  These sector lists are available at Seeking Alpha at http://seekingalpha.com/page/etf-finder and also at Barchart at http://www.barchart.com/etf/sector.php.

    2.  Compare the ETF investment figures and component structures

     From the ETF sector list, you need to study a profile page for each ETF that has the basic information for each ETF such as a general description, top 10 holdings, recent performance returns, dividend information, the management fee, the assets under management figure, and other key data.  As an example of an ETF profile page for the “iShares Dow Jones U.S. Basic Materials Sector ETF” (IYM), go to the Seeking Alpha dashboard page at http://www.seekingalpha.com/symbol/iym  or the Barchart.com profile page at http://www.barchart.com/profile/etf/IYM.  You may also want to visit the home page for the ETF at the ETF issuer’s web site. 

    Investors should carefully consider the list of component stocks that are held by an ETF, looking for component stocks that are likely to produce above-average returns over the long-run for the ETF fund as a whole.  After all, an ETF in the end is simply the sum of its parts.  Investors should also carefully consider the breakdowns of the ETF from the standpoint of geography, market cap, and stock sectors, to ensure that the ETF meets your investment goals and has strong potential for long-term appreciation. 

    3.  Consider the ETF's component weighting system

    The weighting system used by the ETF for its component holdings is often much more important than many investors may think.  An investor that is new to the ETF sector might think that all ETFs are simply weighted by a simple market capitalization scheme like the S&P 500.  However, ETFs use a wide variety of weighting schemes. 

    Most ETFs follow do follow a basic "market capitalization" weighting scheme.  This scheme simply assigns weights to each stock in proportion to its market cap size, meaning that large-cap stocks will have a high percentage weight in the fund and small-cap stocks will have a small percentage weight.  However, in the ETF industry, the raw market cap weighting scheme sometimes needs to be modified so the ETF can meet the diversification requirements of the tax laws and the Registered Investment Company (RIC) rules.  For example, the RIC diversification rules state in part that no single security in an ETF can have a weight greater than 25% and that stocks with a weight over 5% cannot together equal more than 50% of the fund.  RIC requirements can have a big impact on the design of an index weighting scheme when the number of stocks in an index is below about 50.  When there are fewer than 50 stocks in an ETF, most indexes will have secondary rules that adjust the weighting scheme to make sure the index meets the RIC diversification requirements. 

    A market-cap weighting scheme is appropriate for an index that is tracking the broad stock market or a particular stock sector such as energy or materials.  However, an equal-weighted index can be more appropriate when the purpose of the index is to track an investment theme, such as water, that cuts across traditional SIC or GICS industry codes.  A theme-based ETF generally wants to give more equal weights to large and small cap stocks, avoiding the situation where a few large-cap stocks dominate the weighting and performance of the ETF.  An equal-weighted index gives small-cap stocks a larger influence on the overall ETF performance.  As an example of an equal-weighted ETF, the PowerShares Global Water Portfolio (PIO) tracks the Palisades Global Water Index (PIIWI), which is a modified equal-weight index. 

    4.  Consider the historical returns of the ETF

    The historical performance of an ETF is of course interesting to look at but as the saying goes, "past performance is not necessary indicative of future results."  Historical performance can be compared with numerical figures or by doing a chart overlay of one or more ETFs.  An ETF that has performed well in the past will not necessarily perform well in the future.  We like the idea of focusing on an ETF's investment case and its component structure rather than relying simply on backward looking historical performance.  Nevertheless, historical performance is still a factor to consider in choosing between otherwise similar ETFs. 

    5.  Compare expense fees

    The expense fee for an ETF is obviously an important factor to consider in choosing an ETF.  ETF issuers/managers charge the fund an expense fee in return for managing the portfolio.  Finding an ETF with a low expense fee is particularly important when you are choosing a competitive core portfolio ETF such as an S&P 500 ETF.  When ETFs in a particular investment sector are virtually identical, then it only makes sense to choose the one with the lowest expense. 

     On the other hand, if you are looking at ETFs in unique investment areas such as commodities or stock sectors, then we believe you should be less focused on fees and more focused on whether that ETF will perform better than the other ETFs in the sector.  In a sector where you are aiming for a high risk/reward ratio, it doesn't make sense to bypass an attractive ETF just because its fee is 5 or 10 basis points higher than an inferior ETF.  In theory, the potential return that could be earned from the attractive ETF should dwarf the higher expense fee.

    Several large brokerage firms now offer commission-free trading on in-house ETFs.  If you are a customer of a brokerage firm that has in-house ETFs, and those ETFs are virtually identical to ETFs offered by other ETF issuers, then it makes sense to buy the in-house ETF and save the commission expense, particularly if you are engaged in active ETF trading.

    6.  Consider ETF issuer size and quality

    Not all ETF issuers and ETFs are created equal.  There is clearly a big difference between the ETF behemoths in the industry such as iShares and a newcomer to the ETF industry that may not survive.  The ETF industry is a highly competitive business with low fees and low profit margins, making it difficult for small firms to survive.  The larger ETF issuers have large capital bases and enjoy economies of scale on costs, thus providing investors with more assurance about their long-term financial health.  Our advice is to stick with the larger ETF issuers unless a smaller ETF issuer has a particularly unique ETF not offered by the big issuers.

    One of the advantages of an ETF is that it is a stand-alone legal entity and is only managed by its ETF issuer/manager.  If an ETF issuer/manager goes bankrupt, then in theory the funds in the ETF should be left intact because the securities and cash owned by the ETF are in a separate account owed by the ETF fund, not by the manager.  If an ETF issuer/manager goes bankrupt, then the ETF could switch managers or in the worst case the fund will be liquidated and the fund's cash will be returned to shareholders.  However, the funds could be tied up in the fund for weeks or months while the legal process plays out, meaning investors should generally play it safe and stick to large and well-capitalized ETF issuers.

    7.  Consider the ETF's liquidity and "assets under management" size

    When choosing an ETF it is very important to consider the amount of "assets under management."  Generally speaking, the first ETF launched in a particular investment sector often has such a large first-mover advantage that it retains a dominant position indefinitely with the largest amount of assets under management.  Other ETF issuers will often try to launch similar ETFs in that investment sector, but very seldom will a second or third ETF beat the first ETF in the sector, even if the second or third ETF has some more attractive features.  From a liquidity and safety standpoint, it is often better to select the largest ETF in a sector if its attributes are at least as attractive as the smaller ETFs in that sector.

    An ETF that has trouble attracting assets is at risk of eventually being shut down by the ETF issuer and having its capital returned to shareholders.  ETF issuers periodically do a house cleaning and shut down ETFs that have low assets under management and seem to have little hope of gaining traction.  The profitability breakeven points for individual ETFs vary widely in the ETF business, depending on the ETF itself and on the size of the ETF issuer.  However, we would caution against buying any ETF that has less than $10 million of assets under management, unless it is a brand new ETF and seems to be gaining traction.  We would avoid buying an ETF with assets under management of between $10 million and $50 million, unless it is a unique ETF without a larger competitor. 

    Aside from viability issues, smaller ETFs usually have fewer market makers, slightly wider bid-offer spreads, and potentially higher deviations between the ETF price in the marketplace and its net asset value (NAV).  This is another reason to avoid very small ETFs unless there is a particularly good investment case for that ETF.

    The bottom line

    This article presents the basic methodology that an investor can use to choose the best ETF in a class.  In future reports in this series, we will apply this methodology to choose the “Best in Class” ETF for a variety of different ETF sectors.

    From the www.Barchart.com ETF Research Team

     



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Tags: ETF
    Dec 31 12:23 PM | Link | Comment!
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