How To Avoid A Bad ETF

April 24, 2012


Sloppy Exposure

ETFs usually deliver precise exposure to the indexes they track. But what’s in the index? Even among U.S. large-caps, the most famous indexes—the Dow Jones industrial average, the S&P 500 and the Nasdaq 100—provide very different exposures.

To choose the right exposure, certainly look at the returns, but also check for any bias in the holdings.

For example, does your large-cap fund dip too far into midcaps? Does your sector fund deliver the pure-play you want? Look at the pie charts on the fund fact sheets or from other sources.

Many niche funds—those that pass up marketlike exposure in favor of implementing a strategy—often ratchet up risk by reaching further down the market-cap spectrum. In many cases, such exposure is quite intentional rather than sloppy.

Other times, the portfolio drifts beyond its mandate, which brings us back to doing your homework. Know what the fund owns and why.

Other Hazards

Want pure exposure to the price of oil; or to shares on China’s mainland stock exchanges? Beware, because ETFs use futures or swaps to access these assets because there’s no other good way to do it.

Some of Matt’s top-5 worst investments were heavily affected by these barriers.

As Christian Magoon commented at the end of Matt’s article, some of these funds are best thought of as short-term trading vehicles. That doesn’t make them bad funds, but you do need to handle these power tools with great care.

Another factor to watch out for is small asset bases, because that can signal poor tradability and fund closure risk.

Many caveats apply but, in general, the more assets in a fund, the better.

The age of the ETF matters too: If fund ABC has $20 million after three weeks, maybe it’s on a healthy trajectory. But $20 million after three years means the fund needs closer scrutiny.

Get a handle on whether money is flowing into or out of the fund. Our Fund Flows tool is a great way to take quick measure of this variable.

In the end, avoiding a bad investment isn’t always easy. But there’s no reason to pick a bad ETF.


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