ETF landmines

Selecting an ETF: 5 Landmines to Avoid!

Selecting an ETF? ETFs are not all created equal, and some care and attention goes a long way in selecting ETFs. Even if you have a financial advisor, it is well worth paying attention to which ETFs they select on your behalf, and ensure that you are not stepping on these five landmines.

ETF Landmine #1

The ETF with no AUM: AUM stands for Assets under Management. This indicates how large the ETF is. ETFs with low AUM expose the holder to a variety of ills. The first is that they may shut the fund because there simply is not enough interest. If they keep the fund going, they may not put in adequate resources to staff the ETF in order to eke out some semblance of profit. Finally, their costs may raise as they cannot trade enough to get low commission rates. Find an ETF with more than $100 million, and you will avoid these problems.

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Landmine #2

 The ETF has almost no volume.  ETFs that don’t trade present a different problem. While you hold the ETF, there is really no issue, but if you want to sell it, you could face additional costs because even a small sale can move the price down of the ETF. ETFs are traded on the market just like stocks, and when there is a bid / ask spread – then the price will move down to ensure that your ordered is settled. You lose money simply by selling. And in a down market, this phenomenon will be exacerbated.

Landmine #3

The Expense Ratio is very high. Back when ETFs hit the scene they were known as very low cost, efficient assets that were an immediate improvement on Mutual Funds. Mutual Funds were cumbersome to sell, they often imposed exit fees, and they had huge overhead. This overhead is captured by the Expense Ratio. The Expense Ratio is the annual fee that either a mutual fund or an ETF levies on the holder (you). Back when we were less smart, mutual funds were often charging 1.5 – 2% to manage your money. This takes a huge bite out of the returns that you gain. Today, there have been some ETFs that have started charging these large expenses, and it is important to know what you are getting charged to own this asset.  Look for Expense Ratios below 0.5% unless it is a very hard fund to manage (ex. Emerging market funds).

Landmine #4

Some ETFs will expose the asset holder to a wild ride. They may invest in higher risk securities or deploy higher risk investing techniques. All of these are legitimate and may lead to higher returns. But they may be a little to wild for your taste. Two measures will give you an indication of how the fund is run.

Beta is an indication of how volatile the fund is relative to the market as a whole. If it trades with the same variability as the market, the Beta is 1, if it gets above 1.5, you know that you are taking some additional risk. It may be worth it, but you need to be aware that in good times, the fund will be very good, in bad times, well it will underperform.

The other indicator is Management Style. If Management Style is active, that means that the fund is actively engaged in applying judgement on a regular basis that leads to trading. If a fund is passively managed, it will not trade in and out. Rather it will manage the assets with a set of rules that minimize trading. Again, there is nothing wrong with active management, just be aware. 

Landmine #5

Poor Performance will by definition hurt your overall returns that you are getting from an ETF. So it is well worth examining how your ETF has performed. If it has a long enough history, it is best if you can examine performance in a strong market, and a weak market. Look at the table below to see the spread in performance from ETFs that are in the same space of the market. While past performance is no guarantee of future performance, choose one that has offered investors a strong return in the past.

Summary:

ETFs are an excellent asset to hold. In general, they are cost efficient, liquid, and well diversified. There are hundreds of ETFs to choose from, and this competition is forcing all of them to be cost efficient. Please don’t be scared away by this article. My advice is to take a little time when you select an ETF, look under the covers, and ensure that the strategy, the risks, the costs and the performance all line up with what you are expecting.

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