National Post (National Edition)
Not all ETFs are created equal
With the proliferation of Exchange Traded Funds (ETFs) over the past decade, many investors have — rightfully so — gotten rid of their high-fee mutual funds and moved their portfolio over to cheaper
ETFs. Good for them. But, like any product, there are good ETFs and bad ETFs. You need to know what you are buying. You need to know why you are buying one particular fund over another. You need to know if you have too many funds, or not enough, for your investment goals.
There are a lot of issues to cover. Let’s examine one — what to specifically look for when buying an ETF, with thanks to Moez Mahrez at 5i Research, the editor of our ETF and Mutual Fund Update newsletter. Note these points are meant for after you have set your desired asset allocation mix, for when it specifically comes down to buying ETFs in order to establish your investment portfolio.
FEES
Most investors want to reduce fees, but we would not automatically buy the lowest-fee choice of two similar ETFs. You need to look at other factors. But, certainly if you have two virtually identical offerings, choose the one with the lowest fee. Don’t just look at the management fee: some ETFs have higher administration fees than others, which will be reflected in performance as well.
TRACKING ERROR
If you are buying an ETF to represent a market index or a sub sector, it needs to closely match the performance of that index. Wide variance in index tracking will mess up your defined asset and sector allocation. In general, if you own an ETF in an attempt to gain exposure to an asset, and it does not track that asset, something is wrong. ‘Active’ ETFs will have larger tracking errors, as the manager is specifically trying to add value over a benchmark, and may (or may not) succeed. This is fine, and you are paying more for this active approach. But for ‘passive’ ETFs, you want to see tracking error at a minimum.
FUND SIZE
Most investors do not know that a unitholder vote is not required to shut down an ETF. If you buy a small ETF, you could wake up one day and find it closed, causing you to have to rebalance your holdings. This is one reason to avoid small funds: bigger ETFs are more profitable for management companies and far less likely to be shut down. But there are other reasons to avoid small funds, including weak liquidity, higher impact of administration and other fees, and poor bid/ask spreads. Generally, we would suggest only looking at funds with more than $100 million in assets.
TRADING HISTORY/ VOLUME/SPREADS
Higher average daily volume (i.e. number of shares traded) is better — it can prevent a fund from being whipsawed by a few large buyers or sellers, and also ensures you can enter or leave a position at will. Watch out for low trading volumes as they can result in higher spreads, which are added cost when buying and selling ETFs.
CONCENTRATION
Not to be confused with the concentration risk concept in asset allocation (i.e. too many tech stocks), ETF concentration references the number of and exposure to single stocks within the ETF. Many ETFs have highly-concentrated positions, and no matter how low the fee, you do not need to pay it if the exposure can be replicated by owning a few stocks on your own. If say, 60 per cent of holdings are in the Top 10, that is all that is going to really matterat the end of theday,e specially considering the fact that correlations of the other assets in the fund are still likely relatively high. This is a big problem in Canada — healthcare, financials, tech and consumer sector ETFs are all dominated by a few holdings. For example, XIT, the Canadian infotech ETF, has 77 per cent of its assets in just four stocks. For just owning these, and a few others, it still charges a fee of 0.60 per cent.
ETFs are a great solution for do-it-yourself investors who want low fees and diversification. With so many funds to choose from, there is no need to buy a ‘bad’ ETF, so keep these points in mind for your next purchase.