ETFs are fully transparent; they are easy to use; they are tradable; and they are often low cost to own. These are all good traits, but it doesn’t mean investors can’t get it wrong when they choose to use ETFs in their portfolios.
According to Paul Britt, senior ETF Analyst at FactSet, there are four common mistakes ETF investors make:
1. Mistake: Picking an ETF among similar funds based solely on fee differences while ignoring index tracking, trading costs and underlying exposure differences.
When you look for an ETF within a segment, chances are that are several look-alike strategies compete in any given niche. But the funds may be profoundly different, which means their total returns will also differ over time.
Perhaps the easiest way to spot differences is that of cost, but investors should look beyond the price tag to make sure the fund they choose is the best fit for their goal; for example, the two biggest and most popular emerging market ETFs today: the $23.1 billion iShares MSCI Emerging Markets ETF (EEM | B-100) and the $37.4 billion Vanguard FTSE Emerging Markets ETF (VWO | C-89).
From a price perspective, there’s no debate: VWO is the clear winner. The fund has an expense ratio of only 0.15 percent, and it trades with an average spread of 0.03 percent, meaning investors are shelling out only 0.18 percent to own it, or $18 per $10,000 invested.
EEM costs more than three times as much, with a 0.68 percent expense ratio, and an average trading spread of 3 basis points. That puts total cost of ownership of this fund at about 0.71 percent, or $71 per $10,000 invested.
But if you are hoping your exposure to South Korea will come through your emerging market allocation, you will find that VWO falls short. It owns 951 securities and tilts heavily toward China—like the competing EEM—but VWO completely excludes South Korean equities because it deems the country to be a developed market. EEM, meanwhile, has a 15 percent allocation to South Korea—its second-largest country weighting.
There are also differences on the efficiency front—how well they track their indexes. EEM shows a median tracking difference of -0.59 percent over a 12-month period, while VWO’s median tracking difference is only -0.11 percent, according to ETF.com data. That means that on average, both funds slightly underperform their indexes, but that statistic also includes the costs associated with the funds. At the end of the day, VWO is better on average as measured by the median, but the fund also shows more variability in how far up and down it goes relative to the index than EEM does. Ideally, as an investor, you want your fund to replicate the performance of its benchmark as closely as possible.
These differences matter in terms of performance, as the year-to-date chart below shows: