A decade ago, exchange traded funds (ETFs) were barely on investor radars. But since then, the ETF industry has exploded. ETFs are now the bread-and-butter tool for everyday investors looking for an easy way to invest in a particular geographic region, market, sector… you name it.
A record US$3.4 trillion of assets under management (AUM) are now held in ETFs. That’s a nearly 17-fold increase since 2003.
And this trend isn’t slowing down anytime soon…
What’s behind the ETF growth?
First, investors have been disappointed with the relative high-fees and underperformance of active funds (that is, funds where managers select stocks themselves). This has made ETFs, which are low-cost passive funds that simply track a particular benchmark index, more attractive.
For example, analysis from index provider S&P Dow Jones in 2016 showed that 99 percent of actively managed U.S. equity funds sold in Europe have failed to beat the S&P 500 over the past 10 years.
So ETF providers have an easy case to make to investors – why pay more in fees to underperform when you can track the benchmark for nearly free?
Second, the number of ETFs has increased substantially. There are now around 5,000 ETFs listed globally, up from a few hundred in 2003.
Plenty of those ETFs overlap – that is, multiple managers offer ETFs that track the same underlying index – but the everyday investor is truly spoiled for choice when it comes to ETF investing.
To demonstrate just how much choice we have, consider this: there are now more market indexes than there are stocks listed in the U.S.
Today, there are around 3,600 stocks listed on U.S. exchanges (not including the over the counter market), but there are around 5,000 indexes. Not all of these indexes have ETFs attached to them. But to create an ETF, you first need to create an index for it to track.
So the growth in ETF investing isn’t over yet.
At Stansberry Churchouse Research, we’re fans of ETFs. We think they’ve radically democratised the investment process for everyday investors. But like everything in investing, there are some things to watch out for.
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Here are three things you should consider before you buy any ETF:
1. What’s the cost?
ETFs charge a fixed percentage annual running cost to shareholders. This is known as the expense ratio. Whilst an actively managed fund might charge, say, 1 percent of AUM and a percentage of profits, ETF expense ratios are typically less than 0.50 percent. And expense ratios continue to decline…
First, because of scale. As ETF providers gather more AUM, their costs as a proportion of the overall fund size decrease. For example, let’s say it costs US$1 million annually to run, administer and market a particular ETF. That’s 1 percent of a US$100 million ETF. But it’s 0.1 percent of a US$1 billion sized fund.
The second reason expense ratios are falling is competition. Investors are wising up to the impact that fees have on their overall long-term performance. And when you’re looking at two near-identical ETFs that both track the same index, which one are you going to pick? The one with the lowest expense ratio.
But remember, different underlying ETF assets come with different associated expense ratios. If the ETF tracks a major benchmark developed market equity index like the S&P 500, the expense ratio should be low.
But if it holds a wide range of emerging market stocks, expect the expense ratio to be higher. It’s operationally more expensive for an asset manager to replicate a basket of stocks across multiple exchanges, and the expense ratio reflects that.
So how do you know what’s expensive and what’s not? When I want to establish a baseline expense ratio for a particular type of ETF, I check fund manager Vanguard’s ETF page. (Go here to see for yourself.)
Vanguard is renowned for offering the most cost-effective ETFs. It currently offers 55 ETFs across a range of underlying asset classes and sectors. So when I’m comparing the costs of ETFs, I use Vanguard as a starting point for expense ratios.
2. How is the liquidity?
Liquidity is the ease with which you can buy and sell a security in the market without affecting its underlying price.
For most of us individual investors, our individual buy and sell orders don’t visibly move the market. But they can if we’re looking at thinly-traded small-cap stocks.
And some ETFs can suffer from a lack of liquidity just as easily.
The first sign that an ETF you are looking at might not be easy to trade in and out of comes from looking at its AUM. A small ETF is far likelier to suffer from low liquidity than a large multibillion-dollar fund.
The second factor to consider is the nature of the underlying securities in the ETF. If your ETF holds a basket of large-cap developed market stocks, then liquidity won’t be a problem.
If, on the other hand, you’re looking at an ETF like the iShares Barclays USD Asia High Yield Bond Index ETF (Exchange; SGX, Ticker; AHYG), which is an ETF that is small (US$75 million) and holds relatively illiquid assets (Asian high-yield bonds), then liquidity is going to be a problem. (According to Bloomberg, the recent volume of this ETF is less than US$30,000 day, which is very low.)
If you choose to buy a relatively illiquid ETF, please make sure you use limit orders. So when you place your buy or sell order, specify the maximum purchase price (or minimum selling price) you are willing to accept.
3. How does the index work?
I can’t stress this enough – when you are buying an ETF, you’re not only investing in a basket of underlying securities, but ALSO the mechanics of how the underlying index works.
In the early days of ETF investing, this was less of a consideration. Most of the first ETFs sought to replicate standard benchmark indices, like the S&P 500.
But, as I mentioned earlier, there are now more indexes than U.S. stocks and they cover every imaginable type of securities you can think of.
Are you bullish on “cloud computing”? Well, there’s an index for that – the ISE Cloud Computing Index. There’s an ETF for that, too – the First Trust Cloud Computing ETF (Exchange; NYSE, Ticker; SKYY).
If Catholics would prefer to combine their investing with their religion, then look no further than the S&P 500 Catholic Values Index, and the Global X S&P 500 Catholic Values ETF (Exchange; NYSE, Ticker; CATH).
Beyond all of these different sectors and themes, there’s a growing list of “smart beta” indexes. These indexes include more complicated methodologies for how the underlying stocks are selected.
Most indexes use a simple market cap weighted methodology. They take a basket of stocks, and weigh them according to their respective market cap.
But smart beta indexes use factors like trailing volatility (for “volatility targeting” or “volatility reduction” indexes), recent price performance (for “momentum” indexes), or historical dividend increases (for “dividend aristocrats” indexes). These smart beta indexes are applying these methodologies to hopefully provide investors with enhanced returns.
However, investors need to tread very, very carefully with smart beta indexes and smart beta ETFs. They might sound appealing, but you need to ensure you take the time to read through the index construction documents so that you understand what you’re getting into.
As I wrote recently, you can’t just take the name of an ETF at face value and assume it is giving you what it says it is. Always read the label of your investments.
(We’ve recommended smart beta ETFs in The Churchouse Letter in the past – but they require a lot more due diligence and research than ETFs that simply track regular indexes).
So if you’re looking to invest in an ETF, make sure you do your homework. Read the label, and make sure you know exactly what you’re getting into by answering these three questions first.