Learning To Love Little ETFs

September 09, 2014

With so many new strategies on the market, how do you evaluate a tiny ETF?

Deciding among big ETFs is, if we’re honest, relatively straightforward. If you’re trying to decide between the big boys in the large-cap U.S. equity space, you can focus on the subtle cost differences between the S&P 500 giants like the SPDR S&P 500 ETF (SPY | A-98), and compare the exposure differences with something like the Vanguard MegaCap ETF (MGC | A -92).

There are definitely real differences, but they’re mostly in the kind of exposure you’ll be getting (which we put in our Fit analysis) and the costs and tracking difference (which we put in our Efficiency analysis).

But what if you’ve dug into a sector and you’re intrigued by a new take on something? Perhaps you’re looking through the list of Large Cap U.S. Equity ETFs and you stumble across the Compass EMP 500 Volatility Weighted ETF (CFA). How do you know whether you can even consider this tiny, $7 million new entrant?

It’s actually one of the thorniest issues in investing. After all, there’s always an attraction to getting in on the new thing, and often, there can be real rewards as well if your insight into that better mousetrap turns out to be right.

Here’s how I approach the problem:

1) Is the fund truly unique?

Sticking with CFA for the moment, what’s attracting you to the fund? Most likely, it’s a completely unique take on the space. In other words, start your analysis, first and foremost, with fit. In the case of CFA, the “500” in the name has nothing to do with the S&P 500. Rather, it’s a de-novo index that ranks U.S. stocks by market cap, screens for recent earnings and then weights by inverse volatility. It’s a genuinely unique way to tackle the market, and quite different than other low-volatility plays like the PowerShares S&P 500 Low Volatility ETF (SPLV | A-45).

Since the fund is only a few months old, any rigorous academic analysis of real-world performance is off the table, so you’re reliant on claims made by the fund issuer in marketing materials and legal documents about how this strategy may perform in the future. Still, a quick look at “Fit” on its fund page will show you that so far, it’s got a higher beta on up days than on down days, and has a decidedly midcap skew, and has predictable low-volatility industry skews, such as industrials and utilities.

But you shouldn’t stop there. If you’re attracted to the low-vol idea, make the comparisons to the more established funds in that arena (SPLV, or perhaps the iShares total-market take on low vol, the iShares USA Minimum Volatility ETF (USMV | A-59). Then decide for yourself whether you think CFA is worth some additional risk.

Which brings me to the second point:


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