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:

 

2) Does the fund do what it says?

Normally, our Efficiency metric is the shorthand way of answering the question of whether an ETF delivers on its core promise in a way that is reasonable in costs and conservative with structural or other risks.

For a brand-new fund, this is extremely hard to measure. But there are a few things you can look at. The first and most obvious is expenses. Sticking to CFA, the ETF has an annual expense ratio of 58 basis points, or $58 for each $10,000 invested, versus 25 basis points for SPLV, and just 15 basis points for USMV. All else equal, CFA will have to outperform those strategies pretty consistently to earn back that higher fee.

As for risks, the primary ones to consider are structural. CFA isn’t an ETN, so there are no real counterparty risks. Also, as a brand-new fund, it’s unlikely to close immediately. But when the fund enters that dreaded “middle-aged” area—say, one to two years old—and if it still has very low assets and volume, well, it can be very hard to predict if the issuer is going to cut its losses and move on.

Measuring performance can be even trickier. With a bespoke index like the one CFA is tracking, it can take quite some time for data providers to get all their ducks in a row. During that opening few months, investors are really at the mercy of issuers maintaining good information flow.

Unfortunately, Compass doesn’t seem to publish any kind of daily performance information on its website, or that of the index. Worse, that website isn’t really even done yet, as witnessed by this slightly odd disclaimer:

Compass

I’m not just picking on one company here. This is a chronic problem with many new-issuer launches. Without up-to-date information from issuers, how can investors possibly know how well a fund is or isn’t doing? Without that comfort level, how could you possibly be an early adopter?

In the case of CFA, a very deep dive into the Bloomberg terminal suggests that since its inception on July 2, the ETF has returned 0.94 percent, while the index its tracking has returned 1.37 percent. That’s a lot of slippage in a short period of time.

 

2) Can you actually get in and out of the ETF?

Let’s assume for a moment that the fund we’re chasing has passed the first two hurdles: It’s doing something really unique; it’s worth the expense ratio being charged. Also, the communication from the issuer is solid, leading you to believe it’s going to deliver on its promise.

The last question—and often the most difficult—is whether you can really buy it.

If you’re a very large investor, the answer will almost surely be yes. By “large,” I mean your opening position in this new favorite ETF of yours is going to be 50,000 shares or larger. When you look at the success of new issuers like WBI just last month, initial assets didn’t come in because folks went to their Schwab accounts and started gobbling up 1,000 shares at a pop. Instead, major investors and institutions worked with authorized participants and liquidity providers to get big positions done at fair value.

That’s how WBI went from no dollars to more than $1 billion in just a few days. It’s pre-negotiated flow. But even that doesn’t mean it’s suitable for an average investor or advisory client. Consider the WBI Tactical Income Shares ETF (WBII).

It was the big winner of those WBI funds, with $147 million in net flows right out of the gate. In the days that followed, it had some volume … 30,000 or 40,000 changed hands. And then Friday—already a slow day of the week—came, and it traded a whopping 4,108 shares.

Unownable, right?

Well, not really. Most investors would look at that kind of volume and run away screaming. But here’s where slightly smarter trading and really doing some homework makes a real difference. If you go to a Level 2 screen and look at the bids and offers sitting out there, it’s surprisingly healthy:

WBITrade

The left side of the screen is what you can sell it for; the right side of the screen is what you can buy it for.

The fair value (the INAV) for WBI was $25.04 when I snapped this screen from Bloomberg. That means that sellers could move a large number of shares, right at fair value. Buyers would have to pay a 4-cent premium to fair value to get in, or roughly 15 basis points. For a brand-new, illiquid fund, that 15 basis point spread is extremely reasonable.

 

The other thing to look at is the depth. There are real buyers and sellers out there for “WBII,” and not just at 100- or 1,000-share lots. They may not be trading at rapid fire, but this is a real market. Compare this with CFA’s market at the same time:

3_CFA

While this is still a functional market—centered on fair value, which was $35.49 when I snapped this— it’s substantially thinner. There are lower lots, further away from fair value. But it’s worth noting it’s still a functional market, and should the screen continue to look like this, you’d expect to be able to move a few thousand shares in and out with relatively little difficulty. You’d still need to use limit orders, and you might have to simply accept buying on the ask and selling on the bid, but you’d get your trades done without too much chaos.

In other words, while CFA might have failed step 2 of the checklist, both CFA and WBII would probably pass step 3. Yes, they’re illiquid, but their markets are functional and certainly make the ETFs ownable. For comparative reference, this is what a broken market would look like, courtesy if the iPath Global Carbon ETN (GRN):

GRN

The lights are on here, but really, there’s nobody home.

New Funds = More Homework

The bottom line is simple: Investors are often drawn to large, established ETFs because they’re the easy button of investing. Nobody ever lost a client because they picked the largest, most liquid and cheapest ETF in a given asset class. But the newcomers can be owned, often quite easily.

You’ll just have to do a significant amount of legwork to make sure you’re getting the exposure you want—and in a stable package, and you’ll be able to access it through the public markets without too much headache.


At the time of this writing, the author held no positions in the ETFs listed. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.


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