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.

 

 

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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