Picking an Exchange Traded Fund (ETF) can be overwhelming. There thousands of ETFs out there, so the choice is understandably daunting.
Let’s start with a quick refresher on what an ETF is. An ETF provides a way to own a set of investments relatively easily and cheaply. For example, if you wanted to own a set of shares in the Russian stock market, then buying Russian shares yourself would likely be complicated, but a Russian ETF can do it for you. Just as if you owned stakes in many different Russian companies. It’s just like buying a single company on the New York Stock Exchange. The same is true of bonds, you could relatively easy buy some bonds for your portfolio, but actually keeping a portfolio of bonds diversified and well-balanced can be tricky. An ETF can take care of all that complexity for you automatically.
ETFs can also make it simple to invest thematically, I just mentioned the Russia example, and of course, ETFs can be a good way to get exposure to different countries, but ETFs also offer exposure to sectors of the economy such as oil or technology, or stocks with particular attributes to them such as those that pay dividends or are inexpensive relative to their earnings. So ETFs provide a flexible and easy way to create investments. This is, in part, why their usage has grown rapidly in recent years and provided the building blocks for many new financial services.
Nonetheless, there is one catch, there are fees associated with ETFs, called expense ratios. Expense ratios are essentially the main “cost” of the ETF. For the more attractive funds these are typically under 0.60% or so a year (of the amount you invest in the ETF), and often a lot lower. Often funds for passive ETFs are lower than costs for active mutual funds. Also, ETFs can offer access to investment that you couldn’t easily access yourself.
Nonetheless, if you’re constructing your own portfolio directly, you avoid the expense ratio entirely and lower fees have been shown to, on average, lead to better performance. This is according to a number of academic studies of historic performance. So ETFs are inexpensive, but they aren’t generally free. This brings us nicely onto our first rule.
Rule #1 – Less Expensive ETFs Are Often The Better Bet
Fees almost inevitably eat into the return on your investment. ETFs are typically passive products, meaning that they simply track an index, a process that involves good process, but limited judgement and skill. There’s not much magic in it, a fund tracking the S&P 500 is highly unlikely to do it materially better than another fund whether the expense ratio is 1% or 10 times lower at 0.1%. So generally, if you pick a fund with a lower expense ratio, then you get to keep more of your money each year, rather than pay it out in fees.
Therefore, it can be worth paying attention to expense ratios. For example, both iShares and Vanguard have funds that can track the S&P 500 for 0.04% a year (the tickers are IVV and VOO respectively). Consider the rule of thumb that a lower expense ratio is better in most cases. It’s a simple rule, but probably one of the more important of this article. Less is generally more when it comes to ETF fees. The less you pay the more of your money you’re likely to keep because you’re not paying it in fees. Plus unlike other types of purchase, paying more for an ETF probably won’t lead to better quality, or service
Rule #2 - Avoid High Spreads
When you buy a share you don’t pay the average price. When you’re buying you typically pay a little more than the market price, and when you sell you typically receive a little less than the market price. This is how the companies who make a market in ETFs so you can buy or sell whenever you need to typically get paid. They take a small fraction of every trade. This fraction called the “spread” is often very small.
For example, it can often be 0.01% or 0.02% of the amount of the purchase so if you’re buying $1,000 of an ETF if the spread were 0.1% you’d effectively be paying one dollar for the spread. This is a small cost so not something to worry about too much. However, the thing to get concerned about is smaller or illiquid ETFs with larger spreads. If an ETF does not trade frequently, then the spread can be higher than you might expect and that can cost you.
So, sometimes even an apparently cheap ETF can lose some of its apparent cheapness once the spread is considered. Most of the time you can ignore the spread, but in certain circumstances you see ETFs that have a reasonable expense ratio, but very high spreads. In these cases, you may want to pick a different ETF. The site ETF.com has good data on spreads for most ETFs. Again the key here is to avoid unusually high spreads, if you ETF has a spread of 0.05% or less then you’re probably fine and most mainstream ETFs are at that level or lower, but if you’re looking at more unusual or exotic ETFs, then the spread may give you a nasty surprise, so always keep an eye out for abnormally high spreads.
Rule #3 – Securities Lending Policies Can Make A Difference
There’s actually a hidden benefit of ETF ownership, which is securities lending. Basically, other investors may pay to borrow your shares and you can receive a fee for it, or at least the ETF issuer does.
Many ETF issuers will pass on some of that securities lending revenue to you. How much that is worth depends on the ETF, and how much the going rate is to borrow the securities, in certain cases the securities lending policies can actually offset the fee of the ETF itself, so that you are effectively paid a small amount to hold the ETF. This praise may sound risky, but ETF issuers generally have careful policies in place to attempt to control for any nasty surprises and are typically cautious in terms of when and how they approach any lending. Securities lending is not a major factor, but its helpful to invest with an ETF issuer that has a shareholder friendly securities lending policy. Vanguard generally has a relatively generous securities lending policy in place, in terms of the amount of lending proceeds passed on to the ETF investor, though the details depend on the exact fund.
Rule #4 - Commission Free Deals Can Be Worth It
Another cost of buying an ETF is the trading commission. Broadly speaking, this can work out to be $5-$7 per trade and these costs appear to be on a declining trend over time. However, some ETFs are commission-free at certain brokerages. This shouldn’t sway your decision completely, because commissions are just one part of the cost and if you’re planning to hold a position of $5,000 or more in an ETF for several years, then the expense ratio will almost certainly matter more than the commission. Nonetheless, commission free deals can be helpful in reducing the costs of an ETF portfolio.
Rule #5 - Not All ETFs Are Sensible, Long Term Investments
ETFs started has a way to passively track many well-constructed indices. This makes ETFs a useful tool for many longer term investors. For example, the ability of the Vanguard Total World Stock ETF to track global equity markets for an expense ratio of 0.11% a year in expense ratio, appears helpful to many looking for low-cost global diversification. Yet, over time, ETFs have seen massive growth and there are now thousands of ETFs of many different styles and types.
A lot of ETFs still truly are reasonable long-term investments if history is any guide. However, there are also ETFs that are more specialist and speculative. For, example anything with ‘Ultra’ or ‘3x’ in the title is likely a leveraged ETF, these can do much better than the index on good days for the markets, but on bad or even flat days, then can do much worse. Over time, the high fees associated with leverage can really eat into returns. Some people use these for short-term trading, which is fine assuming they know what they are doing. Yet, using leveraged ETFs as a longer term investment vehicle can be risky. Sticking with passive indexing of the stock and bond markets rather than using leverage can be a better way to preserve wealth over the longer term.
Rule #6 – Start With An Asset Allocation Before You Look For ETFs
Finally, a reminder that if you’re looking to build a portfolio, this shouldn’t be the first article you read. Picking robust ETFs is important, but it’s a secondary topic once you have an asset allocation in place. ETF selection makes sense within the context of an overall investment strategy. Assembling a set of ETFs that look good on above criteria will not automatically get you to a strong portfolio that meets your needs, in the same way that picking items on sale when you go food shopping won’t get you to a balanced meal. Make sure you start with an overall investment strategy before you pick your ETFs. For example, you could start by taking a look at how Harvard and Yale invest if you have long-term investing in mind.