Questions To Ask Before You Buy An ETF

How do you choose the right ETF? Here are seven questions that will guide your research.

Choosing the right ETF is difficult. With more than 1,600 ETFs on the market and more than 100 new ones launching every year, it’s hard to even keep up with what’s available on the market.

But finding the right ETF matters … a lot. Consider that:

• Over the past 12 months, the difference between the best- and worst-performing gold miner ETF was more than 16 percent.
• Over the same time period, the difference between the best- and worst-performing biotech ETF was more than 14 percent.

I could go on.

Fixed income, commodities, currencies or alternatives … it doesn’t matter where you look; there are vast differences between competing ETFs.

Later today, I’ll be conducting a webinar with my colleague Dave Nadig, discussing how we go about evaluating ETFs. You can register to attend that webinar here. In the meantime, here are seven questions to help guide your due diligence process.

1) Is it fairly priced?

ETFs are mostly cheap, and that’s a good thing. After all, investing is one of the few areas in life where you get what you don’t pay for. Studies—like this one from Morningstar—suggest that expense ratios are one of the best predictors of future fund performance: the lower, the better.

Given that, you’d think ETFs would cluster around the low end of the fee spectrum. Unfortunately, that’s not completely true.

For broad-based emerging market equity exposure, for instance, you could pay 0.14 percent in annual fees for the Schwab Emerging Markets Equity ETF (SCHE | B-89) … or 1.16 percent per year for a fund from ALPS and Goldman Sachs (ALPS/GS Momentum Builder Growth Markets Equities and US Treasuries(GSGO | D-27)) that rotates between direct emerging markets equity exposure and U.S. Treasurys. In between are funds like the Guggenheim MSCI Emerging Markets Equal Weight ETF (EWEM | F-74), charging 0.70 percent for fairly basic exposure.

Does it matter much if you pay 0.14 percent for SCHE or 0.15 percent for the Vanguard FTSE Emerging Markets ETF (VWO | C-91)? Of course not. But paying an extra 0.50 percent a year or more should make you stop and think.

2) Does it track its index well?

Finding an ETF with a low expense ratio isn’t the end of the road. We also suggest you look at how well an ETF tracks its index. After all, if a fund charges 0.15 percent but trails its benchmark by 0.75 percent, that doesn’t do you much good.

At ETF.com, we keep track of a statistic called “Median Tracking Difference.” You can find it on the Efficiency Tab for any fund in our free ETF Analytics system. Median Tracking Difference examines how far, on average, a fund trails its index over a one-year period.

For example, the aforementioned SCHE charges 0.14 percent, but only trails its index on average by 0.04 percent a year. In other words, it’s earning back nearly 0.10 percent of its expense ratio through savvy management, securities lending and other activities.

By contrast, the equal-weight emerging markets ETF—EWEM—has trailed its index by 1.79 percent per year on average, despite charging “just” 0.70 percent in fees. Ouch!

Watch tracking difference: It’s the best indicator of the experience the average investor has in a given fund.

3) Does it have any blowup risk?

Once you’ve found a fund that charges a reasonable fee and tracks its index well, you have to ask yourself if there is any blowup risk. Is the fund unpopular and the ETF provider likely to shut it down? If it’s an exchange-traded note, does it have significant counterparty risk? Does it have a history of paying out capital gains distributions?

We track this information and more on the Efficiency tab of our fund analyst reports.

4) Do you understand the tax treatment?

Before you move off of fund structure, ask yourself, Do I understand the tax treatment of this ETF? ETFs have opened up awesome new areas of the market like commodities, currencies and alternatives, but the tax treatment for these market segments is not always simple.

The SPDR Gold Fund (GLD | A–100), for instance, is one of the top 10 ETFs in the world by assets. But how many investors know that it’s considered a “collectible” by the Internal Revenue Service? That means no matter how long you hold GLD, you’ll never qualify for long-term capital gains treatment. You’ll owe the 28 percent capital gains tax treatment on your gains when you sell.

If you’re confused, check out Dennis Hudachek’s Definitive Guide to 2014 ETF Taxation. It will tell you everything you need to know.

5) Can you trade it at a reasonable cost?

The next question to ask is, Can I trade this fund at a reasonable cost? It’s no good to have a low-cost, well-structured ETF if you have to pay a 1 percent spread every time you want to enter or exit the fund.

The familiar metrics for evaluating tradability include:

• Average and median spread: the lower the better
• Average and Median Daily $ Volume: the higher the better

If you’re trading large quantities of an ETF, you might also want to look at how liquid the underlying securities the ETF holds are. If you own a Bloomberg terminal, it has a decent measure of underlying liquidity, as explained here.

Alternatively, ETF.com provides similar information on the Tradability tab of our ETF.com Analytics reports, analyzing data points like the “Underlying Volume Per Unit,” i.e., what percentage of the ADV of the holdings of a given ETF do you have to buy to purchase a “creation unit” (typically 50,000 or 100,000 shares) of an ETF? Alternatively, our overall “Tradability” score captures both underlying liquidity and spreads in a single measure.

6) Are you paying a fair price?

It can sometimes be hard to tell if you’re paying a fair price for an ETF. For instance, if an ETF tracks the Japanese market, there’s no way to tell what the value of the ETF’s holdings are at any point during the U.S. trading day. After all, the Japanese market is closed during U.S. trading hours.

The best guidance here is threefold:

• First, if you’re looking at a domestic equity ETF, check the “iNAV.” This is a statistic that ETF issuers are required to disseminate providing a real-time estimated value of the holdings of an ETF. For U.S. equity ETFs, it’s a great guide to paying a fair price.

• Second, focus on ETFs with significant trading volume. An ETF trading 10 million shares a day is less likely to have a pricing error than one trading 10,000 shares a day, simply because more people are looking at it.
• Third, check for “Impediments to Creation.” The only time that ETF prices get really out of whack is when something breaks down in the way either the ETF or financial markets in general work.

  We saw this in the Market Vectors Egypt ETF (EGPT | F-47) during the Arab Spring, when the Egyptian equity market shut down and the fund traded to huge premiums. We see it even today in products like iPath Dow Jones- UBS Natural Gas Total Return ETN (GAZ | D-65), which is closed for creations, meaning no new shares can be created.

  When there is an impediment to creation, funds can trade to huge premiums and discounts, and should generally be avoided. (You can find that data point in the Tradability tab of our reports.)

7) Does it really capture the market you want?

Finally, you come to the most important question: Does this fund really capture the market you want to track?

Consider the biotech segment I mentioned above. One fund—the SPDR S&P Biotech ETF (XBI | A-42)—tracks an equal-weighted index of biotech companies, which means it skews toward small-cap companies: The average market cap of its holdings is just $7.8 billion. XBI is up just 13.69 percent in the past year.

Another, the iShares Nasdaq Biotechnology ETF (IBB | A-37), tracks a market-cap-weighted index, which means it skews toward the big guys. Its average market cap is $37 billion. It’s up 26.65 percent last year.

Certainly, 26.65 percent versus 13.69 percent is a big gap! All you had to do is take the time to ask, Do I want to invest in small startups or big, established biopharmaceuticals?

The question “Does it really capture the market you want?” can be critically important as you get into more complex areas of the market. Of the three BRIC ETFs, for instance, one has a 13 percent weight in Russia and one has a 25 percent weight. With the current situation in the Ukraine, that’s something to consider.

And when you get to the market’s more esoteric corners, choosing right and understanding your exposure gets downright critical. I weep about the billions of dollars that’ve been lost by investors buying the iPath S&P 500 VIX Short-Term Futures ETN (VXX | A-47) thinking they were buying VIX exposure. That fund is down 99.7 percent from its highs.

Summary

Does it take some work to find the right ETF? Yes, but the work pays off. Just a bit of time looking at the fees, expenses, blowup risk, trading costs and portfolio of an ETF can mean the difference between cleaning up and getting taken to the cleaners.

The good news is, there are a lot of tools out there to help, from ETF.com’s own ETF Analytics tool to offerings from Morningstar, ETFdb and others.

Take your time, choose wisely and get the ETF you deserve.

At the time this article was written, the author held a long position in VWO. Contact Matt Hougan at [email protected].