A beginner’s guide to ETF Investing

What is an ETF?

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

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

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

ETF history

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, they became a favorite investment vehicle for individual investors and asset managers. Today, globally, there are 6,870 ETF products on 60 exchanges and over $5 trillion of assets under management.

ETF vs. Mutual Fund

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 many individual investors.

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 the 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 purchase these funds on the stock 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.

Exchange Traded Notes

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 a higher risk profile.

Smart Beta ETFs

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 and index management. 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 fund will buy only the securities provided by the model. The multi-factor ETFs are competing directly with mutual funds, which use similar techniques to select securities. However, they have a lower cost, better transparency, and an  easy entry point.

Currency Hedged

Currency Hedged International ETFs is another newcomer in the 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 funds in this category include HEDJ, which tracks Europe developed markets, and DXJ, which follows Japan exporting companies.

How to invest?

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

For now, they 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. Their tax treatment follows the tax treatment of their underlying assets.