A beginner’s guide to ETFs

Guide to ETFs

A beginner’s guide to ETFs. The ETF industry was born as a result of the market crash in October 1987. The initial goal behind ETFs was to provide liquidity and mitigate volatility for market participants. Over the last 20 years, ETFs became a favorite investment vehicle for individual investors and asset managers. Today, globally there are 6,870 ETF products on 60 exchanges and over $3 trillion of assets under management.

ETF stands for an exchange-traded fund. ETF is a passively managed marketable security that tracks an index, a commodity, or pool of bonds. ETFs trade on the stock exchange and their price fluctuates throughout the day.

The media and investors often compare ETFs with mutual funds.  In contrast with ETFs, the mutual fund managers actively look for securities in an attempt to beat their designated benchmark.

ETFs typically have higher daily liquidity and lower fees than most mutual funds.  This makes them an attractive alternative for individual investors.

By design, ETFs do not produce positive alpha. Alpha is the difference between the fund and the benchmark performance.  ETFs strictly follow their index, and as a result, their alpha is always zero.

ETFs popularity spiked in the past five years due to the rise of robo-advisers and lowering management fees. At the same time, many emblematic active managers underperformed their benchmarks and saw significant fund outflows.

To illustrate this, in 2015 Morningstar reported a $206.7 billion outflow from active funds and a $412.8 billion inflow in passive strategies.

 

Underlying Index

There are significant variations in the index composition between indices tracking the same asset class.  The ETFs structure and performance reflect these differences.

In the small-cap space, for example, IJR tracks the S&P 600 Small-Cap index, and IWM follows Russell 2000 Small Cap index. As the name suggests, the S&P index has 600 constituents, while Russell index has 2,000 members. While there are many similarities and overlaps between the two, there are also significant variations in their returns, risk and sector exposure.

In the Emerging market space, indices provided by MSCI include South Korea in their list of emerging market countries. At the same time, indices run by FTSE exclude South Korea and have it in their developed country list.

Investors seeking to manage their exposure to a particular asset class through ETFs need to consider the index differences and suitability against their overall portfolio.

 Fees

The fees are the cost associated with managing the fund – transaction cost, exchange fees, administrative, legal and accounting expenses. They are subtracted from the fund performance. The costs are reported in the fund prospectus as an expense ratio. They can be as low as 0.08% and as high as 2% and more. The percentage represents the total amount of management fees over the value of assets under management.

Consider two ETFs that follow the same index.  All else equal the ETF with the lower fee will always outperform the ETF with the higher one.

Liquidity

The ETF liquidity is critical in volatile markets and flash-sales when investors want to exit their position.

Asset under management, daily volume, and bid/ask spread drive the ETF liquidity. Larger funds offer better liquidity and lower spread.

The liquidity and the spread will impact the cost to buy or sell the fund. The spread will determine the premium you will pay to buy the ETFs on the stocks exchange. The discount is what you will need to give up to sell the ETFs. The lower the spread, the smaller difference between purchase and sale price will be. Funds with less spread will have lower exit costs.

ETF varieties

Exchange Traded Notes are an offshoot of the ETFs products. ETNs are structured debt instruments that promise to pay the return on the tracking assets. This structure is very popular for Oil, Commodity and Volatility trading. They offer flexibility and easy access for investors to trade in and out of the products.

I believe that long-term investors should avoid Exchange Traded Notes (ETNs), volatility (VIX) ETFs, inverse and leveraged (2x and 3x Index) ETFs and ETNs products. While increasing in popularity and liquidity, they are not appropriate for long-term investing and retirement planning. These types of funds are more suitable for daily and short-term trading. They incur a higher cost and have higher risk profile.

Smart Beta ETFs are also increasing in popularity. While the name was given for marketing purposes, this particular breed of ETFs uses a single or multi-factor approach to select securities from a pre-defined pool – S&P 500, Russell 2000, MSCI world index or others.

The Single Factor ETFs like Low Volatility or High Dividend are strictly focusing on one particular characteristic. They offer a low-cost alternative to investing in a portfolio of income generating or less volatile stocks.

The multi-factor ETFs are a hybrid of active management and ETFs. ETF providers have established an in-house index that will follow the rules of their multi-factor model. The model will select securities from an index following specific parameters with the intention of outperforming the index. The ETF will buy only the securities provided by the model. The multi-factor ETFs are competing directly with the actively managed mutual funds, which are using similar techniques to select securities. Their advantage is the lower cost and easy entry point.

Will smart beta ETFs succeed? Only time will tell. For now, we don’t have enough historical data to confirm their ability to outperform their index consistently.

Currency Hedged International ETFs is another newcomer in the ETF space. Their goal is to track a foreign equity index by neutralizing the currency exposure. They can be attractive to investors with interest in international markets who are concerned about their FX risk.  Some of the more popular ETFs in this category include HEDJ, which tracks Europe developed markets, and DXJ, which follows Japan exporting companies.

Where to place ETFs?

ETFs are a great alternative to all investment accounts.

Due to their passive management, low turnover and tax-advantaged structure ETFs are a great option for taxable and brokerage accounts.

For now, ETFs have not made their way to corporate 401k plans, where mutual funds are still dominating. I am expecting this to change as more small and mid-size companies are looking for low-cost solutions for their workplace retirement plans.

Tax-sensitive investors, however, need to consider all circumstances before adding ETF holdings to their portfolio. The ETF tax treatment follows the tax treatment of their underlying assets. Qualified dividends paid by your ETF will trigger a favorable rate of 0%, 15% or 20%. The interest from bond ETFs and dividends from REITs are taxed at the ordinary tax income rate of up to 39.6%.

Higher-yielding ETFs like those tracking REITs, High Yield, and Emerging Markets Bonds are suitable for the tax-advantaged accounts like 401k, IRA and Roth IRA where their income will be sheltered from taxes.

Equity Growth, Municipal, and MLP ETFs have favorable tax treatment, which makes them a great fit for taxable investment accounts.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of the article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions.  Various sources may provide different figures due to variations in methodology and timing.
Resources:
Great Bloomberg article about the history of ETFs:
http://www.bloomberg.com/features/2016-etf-files/
2015 Morningstar Direct U.S. Asset Flows:
http://corporate.morningstar.com/US/documents/AssetFlows/AssetFlowsJan2016.pdf

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