Matt Hougan: Thoughts on Choosing the Right Sector ETF

Includes: IBB, PBE
by: IndexUniverse

As a prelude to our upcoming live discussion on Choosing the Right Sector ETF (this Thursday at 2pm ET), we asked Matt Hougan of a few questions:

1. What are the key factors you're looking for when choosing a particular ETF among many available to capture a given sector?

I look at three things: coverage, quality and liquidity.

Coverage means how well an ETF captures a given sector or industry. If I'm making a bet on biotech, for instance, I want my ETF to capture the classic "biotech" sector. I don't want it to make big bets that are out-of-line with the market. So I'll look at the holdings and compare them with a classic, market-cap weighted portfolio and try to understand the differences.

Quality means how well an ETF does what it is supposed to do. Does it have low expenses, low tracking error, good tax efficiency, etc. Is there a risk it will shut down?

Liquidity means just that: Can I get into and out of the ETF efficiently and at low costs. I look at spreads and assets. Larger investors can consider a fund's "implicit liquidity," or the liquidity that exists in the creation basket.

2. Can you give an example of two sector ETFs that you considered, and why you chose one over the other?

Sure, let's stick with biotech. There are six biotech ETFs, and let's just compare two: IBB and PBE. IBB is a giant, liquid, well-established ETF that provides market-cap-weighted exposure to the classic biotech industry; PBE holds an idiosyncratic portfolio of biotech names, missing a number of large companies altogether (Genzyme (GENZ), Vertex (NASDAQ:VRTX), Dendreon (NASDAQ:DNDN), etc.). It's also more expensive and less liquid.

If you decide as an investor to skew small in your biotech picks, PBE could be a good choice. But if you want "biotech" in the classic sense, IBB is a natural choice.

3. Is ETF selection and portfolio construction something the individual investor can effectively do on their own, or given the complexities and the dynamic nature of this market, do you think it's best left to a professional?

People can build a solid, basic portfolio on their own. It's not that difficult to build a portfolio that will outperform the majority of investors, simply by avoiding the performance-chasing mistakes and high fee funds that so many people choose.

But high-quality financial advisors provide real value, and there are plenty of people who do not have the time, interest or inclination to go it on their own. For them, working with a fee-only fiduciary makes a great deal of sense.

4. Where do you get your news and views on ETFs? Are there particular sites or resources that are indispensable in your ETF selection and reference process?

I scour the Web for news on the ETF market to produce our own publications in the space (, ETFR and the Journal of Indexes). I certainly keep an eye on publications like ETF Trends, ETF DB and Morningstar, as well as the Wall Street Journal, FT and Marketwatch.

There's great data and tools available from all the ETF issuers. Investors can do amazing things just looking at issuer web sites and using free tools like Yahoo Finance.

5. What are your thoughts on the relatively new actively managed ETFs? If an investor is interested in purchasing an actively managed ETF, what are the important elements to look for?

I think active can make sense in certain corners of the bond market and in commodities. Outside of that, it's a tough sell.

The single best predicator of long-term active fund performance is the expense ratio: the lower the better. So if you're looking for an active fund, that's one place to start.