How To Avoid A Bad ETF

April 24, 2012

There’s a difference between a bad investment and a bad fund. While neither is much fun, bad funds are definitely avoidable.

I got started on this topic after Matt Hougan wrote about the five all-time worst ETF investments.

Matt’s list of losers included contenders from both the bad-investment and bad-fund camps, but as I said, avoiding bad funds is generally a whole lot easier than avoiding bad investments.

I’ll look at trading costs, fees, questionable investment exposure themes and a few other stumbling blocks.

Trading Costs

I’ll start with trading costs, in part because I’m guessing that many investors—especially those used to mutual funds—overlook trading costs. But trading costs are an annoying fact of life for investing in ETFs, and getting a handle on them isn’t easy due to their complex and dynamic nature.

No single data point tells all, but average bid/ask spreads and average daily dollar volume convey a lot.

Get information from our data tool or other sources. Be sure to look at spreads as a percentage of share prices, not cents. That makes for meaningful comparisons, whether the funds you’re looking at are worth $100 or $20 a share.

But what is a tight spread, and how much volume is enough?

Holding up your fund against mega-volume funds like the SPDR S&P 500 (NYSEArca: SPY) may not help much.

Instead, compare the same data point across the funds you’re interested in. In general, high-volume correlates with lower spreads, though exceptions are frequent.

You may wonder why you need to worry about volume at all if it’s the spreads that affect your wallet. The answer is that spreads represent an average, and spreads can vary considerably from day to day. All of this affects returns, which is what investing is all about.

To that end, you should also eyeball the fund’s volume each day over the last one or two months. (Google, Yahoo and others list volume daily next to historical prices.)

A fund with reasonable-sounding average volume might have racked it all up in one day last month, with lots of thin days since then. Avoid these types of funds if you can.

A worthwhile side note is that ETFs that trade poorly for smaller orders can often be traded in large blocks much more economically with the help of a liquidity provider.

While this apparent contradiction does hold true, factor in whether you’ll need to trade in smaller—and more costly—sizes in the future to rebalance or tweak an allocation.

High Fees

Avoiding funds with high expense ratios sounds like a no-brainer, but it’s not.

A 50 basis point fee is dear for a basket of U.S. large-caps, but cheap for an emerging market debt portfolio.

What you need to do is define the group of funds you’re interested in—our ETF finder is a great tool—then compare the fees.

Unfortunately, the headline fees on a fund’s fact sheet, or even on a Bloomberg machine, aren’t always reflective of all-in fees.

For most U.S. equities, what you see is what you get.

But for other asset classes like commodities and alternatives, the headline fee number may not tell the whole story, as my colleague Carolyn Hill pointed out recently.


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