No eye test or gut feelings when considering which ETFs to use in iSectors strategies
Posted on: 03/20/2015
Today’s Throwback Thursday post falls on the first full day of the NCAA Men’s Basketball Tournament. As people all across the country fill out their brackets, trying to predict the eventual winner of the 68 team tournament, there is certainly a great deal of thought involved. However, this thought is often rooted in “gut feelings” or “eye tests.” There is hardly ever any thought given to actual research of these teams and their stats in attempting to pick a winner! A team’s past performance over the course of this season doesn’t necessarily guarantee that team will win in the tournament, but it’s certainly useful information when considering other factors alongside the pick for each bracket.
Does this sound familiar? It should because many times the example given above for picking a bracket is used by investors when picking ETFs (this is where financial advisors can truly prove their value, as we’ve discussed in the past). iSectors does not use the “eye test” or “gut feelings” when considering which ETFs to use in our strategies. We utilize a very thorough research process for each of the 100-ish ETFs we own which includes data from Morningstar, the various ETF providers we have relationships with, and from each of the ETF fact sheets. Speaking of fact sheets, they are actually the focus of this week’s “throwback article.”
Originally published in May 2010 on DailyFinance.com—not long after the Flash Crash, iSectors CEO Vern Sumnicht was quoted in the article, “ETF Basics: How to Dissect an ETF Fact Sheet.” The article covers what is present on ETF fact sheets, along with what is most important to pay attention to, and what might not be as important when analyzing an ETF. Vern discusses the use of leveraged ETFs, which are at times used in the iSectors Post-MPT Growth Allocation. Enjoy our throwback article …and good luck with your bracket!
ETF Basics: How to Dissect an ETF Fact Sheet
Sheryl Nance-Nash – May 18th 2010
There’s no sense kidding yourself. What are the odds you are going to read the prospectus for the exchange-traded fund you’re considering investing in? You know you should plow through all the pertinent information they provide, though it’s hardly page-turning material — but knowing and doing are two different things. Face it — most of that ETF prospectus is going to remain unread by you.
However, all is not lost. You can get a fair idea about what you’re buying by reading the ETF fact sheet. Here’s some of what really matters.
Suss Out the Strategy. “What does the fund do?” asks Michael Iachini, director of investment manager research at Charles Schwab Investment Advisory (SCHW). “You want to know how it will fit in your portfolio? Is it buying stocks, bonds, commodities, derivatives, what?”
Know the Expenses. A major advantage of ETFs versus mutual funds is that they have lower expenses due to less trading activity and lower research costs. “Average mutual fund management fees are 1.4%,” says Alan Segars, investment management officer of The Provident Bank’s wealth management department. Many ETFs can be had for much less. Remember: The lower, the better. “The less you pay in expenses, the more you keep in returns,” says Iachini.
What’s in the Kitty? The top 10 securities in the ETF portfolio indicate the degree of concentration and exposure to individual issues or groups of issues, points out Segars. Unless you’re looking for an ETF that holds one particular asset, such as gold, lower levels of concentration are better. “This minimizes risk of the fund performing badly because of bad news for one particular company it holds,” says Iachini.
What’s in the Mirror? An ETF attempts to replicate a specific index and its investment results, even if it doesn’t hold precisely what’s in that index. Consequently, it is important to focus on the index description, which can provide information to determine if the ETF is an appropriate investment for you, based on your investment objectives and risk tolerance.
How Busy is This Baby? What is the average daily trading volume? The higher the better. Look for at least $1 million per day, says Iachini. If the volume is too low, the bid/ask spread is likely to be wide, adds Iachini.
Is This ETF a Twin? How closely does your ETF track the index it’s supposed to replicate? The closer it comes to the benchmark, the better. You don’t want to buy a fund that aims to track an index and then fails to do so, says Iachini. So, examine the contents of the fund: What’s the ratio of individual holdings in the ETF to the number that are in the index? This comparison provides an indication of the percentage of securities the fund is using to replicate the index. In general, says Segars, the lower the percentage, the greater the chance for tracking error.
What’s the History? Higher performance is better. But don’t pick an ETF based solely on past performance, pick one based on the way it fits into your portfolio, advises Iachini. When was the ETF established? Relatively new ETFs might require an extra measure of due diligence, or an “incubation” period, before diving in, cautions Segars. Another important statistic to keep an eye on is the historical premium/discount of ETF share price to net asset value. “This data represents potential friction or costs, that an investor may bear over and above the intended index performance,” explains Tim Knepp, chief investment officer at Genworth Financial Wealth Management. The discount/premium between the ETF’s price and its net asset value should be as close to zero as possible, so as to minimize the possibility that you’ll be buying at a premium and selling at a discount, says Iachini.
What’s Uncle Sam’s Cut? Tax efficiency is one of the big advantages of an ETF: Capital gains taxes on them can be delayed. A fund’s “after-tax held returns” figure tells you how well it did assuming no shares have been sold, while its “after-tax sold returns” number factors in the taxes on distribution and sale of fund shares. “To the extent that these numbers are close, the fund is providing tax efficiency,” says Segars.
Location, Location, Location. Are the fund’s assets all in the U.S., all overseas, or a combination? Do they concentrate in one country or region, asks Iachini.
Bigger Can Be Better: When it comes to assets under management, the higher the amount, the better. Don’t go below $20 million, says Iachini. “Funds that are too small may not be able to efficiently track their indexes and may be more prone to liquidation. Their costs are also likely to be higher,” he adds.
Duration/Credit Quality. For a bond ETF, you want to know how much risk you’re getting.
Leverage — A Double-Edged Sword: Many index-based ETFs use double or triple leverage, meaning they seek to achieve a return that is a two or three times their index’s performance. But doubling down on the upside means you’re also doubling down on the risk. “Without doing some basic research, you could find that when the S&P 500 index dropped by 15%, your S&P 500 ETF investment was down 30% to 45% — not the kind of surprise you’d like to see in your investment portfolio,” says Vern Sumnicht, CEO of iSectors.
While reading the fact sheet is no substitute for carefully examining the whole prospectus, it’s a good starting point, and it can provide you with enough information to make the investment choice that’s right for you.