There’s a way to eat spaghetti with less mess and it involves a spoon, or if you’re from the old country, an artful twirl with the fork. Choosing the right ETF for your portfolio is a similarly underappreciated art.
That’s more true now than ever. Out of 1,923 exchange traded products listed on U.S. exchanges on the stock market today, roughly 160 have launched in 2016 so far.
Some new funds are truly helpful, thoughtfully executed ideas — such as the international counterpart to Vanguard Dividend Appreciation (VIG). Other newfangled products betray a wild-eyed grab for attention and profits, offering up yet another novel asset class that investors never asked for and probably will never need.
The mushrooming number of products has consequences for the investing public, says Ben Johnson, director of global ETF research for Morningstar.
“The asset-management industry has blasted its spaghetti cannon, with investors playing the role of the wall,” he wrote over the summer. Extending the metaphor further, Johnson noted that “many investors have displayed a nonstick coating,” batting away the likes of Sprott Buzz Social Media Insights (BUZ) and Global X Millennials Thematic (MILN). But, he cautioned, “that won’t keep the industry from firing volley after volley, trying to get something to stick.”
Investors in ETFs are looking for ways to sift through the bewildering array of choices. So IBD reached out to the big-money pros for whom investing in funds is the cornerstone of daily business. We asked them how they go about choosing an ETF for client portfolios, both what they look for and what they look to avoid.
Click Here To See A List Of Top Performing ETFs In 2016
Their ideas may help you become successful investors too. How a fund performs is important, of course, but evaluating funds for performance can be nuanced in the ETF context, as a money manager we interviewed said.
Astor’s Bryan Novak recommends scrutinizing both the qualitative and quantitative aspects of an ETF to make sure it matches your investment objective. Bill Roach of Globalt outlines his routine for filtering the masses of ETF choices down to a more manageable list.
Todd Rosenbluth, the funds guru at S&P Global, highlights an often-overlooked, but critical, aspect of ETF selection.
Here’s what they have to say:
‘Break Up The Selection Process’
Bryan Novak is senior managing director at Astor Investment Management, a $1.8 billion registered investment advisor that provides investment solutions using proprietary macroeconomic analysis. Astor has been utilizing ETFs for almost two decades to manage client portfolios across multiple asset classes. The firm’s investing philosophy centers on the belief that economic fundamentals matter and its objective is to protect client assets from wealth-destroying events by providing the right allocation strategy.
The proliferation of exchange traded funds has made these investment vehicles the ultimate asset-allocation tool, for individual investors and institutions alike. ETFs offer the ability to achieve exposure with one click to a variety of asset classes and risk exposures — broad U.S. equity, specific industrial sectors, large and small caps, international, fixed income, and much more.
ETFs offer several advantages: They trade throughout the day like stocks and offer relative tax efficiency vs. the mutual fund. These advantages make the decision to use ETFs fairly easy. The question then becomes which ones to select for your portfolio. This part of the process takes some thought.
Following the example of institutional investors, retail investors can become more educated and empowered when choosing ETFs to achieve a first-class portfolio to pursue their goals.
Over time, we’ve watched the ETF space expand, making many more choices and varieties of these investment vehicles available. While having more choice is good, it also necessitates having a due diligence process to find the right ETFs to efficiently address portfolio objectives. For retail investors, doing a few key assessments can help turn their portfolios from average to top notch.
The first consideration is asset allocation or exposure. This process determines where investors want or need exposure, based on their time horizon and risk tolerance. How much equity vs. fixed income? Are they selling some stock holdings for tax purposes, but want to maintain market exposure? Once those questions are answered, the next step is selecting the right ETFs to do the job.
At Astor, we break this process up into two segments — qualitative and quantitative. In the qualitative part of the process, we examine the characteristics of the ETFs to make sure they match our investment objective. A few questions to ask are:
- Does the underlying index provide the desired exposure? Some index providers weight stocks in a given sector or market cap differently than others.
- What is the ETF’s process for weighting stocks and how often does it reweight or rebalance? Some ETFs are designed with alternative weighting methodologies — for example, Guggenheim S&P 500 Equal Weight (RSP) gives the same weight, or importance, to all the stocks in the S&P 500, while SPDR S&P 500 (SPY) weights the same stocks by market capitalization (or the market value of a company’s outstanding shares). Also, the timing of rebalance may impact the composition of an ETF’s holdings.
- Does the company issuing the ETF have a good track record of managing investment products? To find that out, investors can research its experience in managing funds, as well as whether it provides the right resources to evaluate the funds. Those resources can provide ongoing value for an investment.
These questions may require some digging, but are worth looking into.
The next round of due diligence focuses on the quantitative, or number crunching. Many of the answers to these questions can be found in the ETF prospectus or on common investment-research sites such as Morningstar.
- How much does the fund cost, as reflected in its expense ratio? Fees vary from fund to fund. Generally, you do not want to overpay for the same market exposure that can be replicated more cheaply with another ETF.
- How does the ETF track its underlying index? The issue here is how well an ETF delivers what it promises in terms of exposure to a specific index. Typically, the lower the tracking error, the better. This can be researched on websites such as ETF.com. Tracking error to the upside is good, but investors should understand why, i.e., an active ETF may be able to consistently outperform an index.
- What are its assets under management? Generally, an ETF’s asset level may give some indication about how likely it is to stay open.
- How tight is the market for this ETF, as reflected in the bid-ask spread? All else equal, a tighter market is better. As ETFs are a basket of stocks, there is usually more liquidity in an ETF from brokers than what the market shows. Limit orders can help access that liquidity.
By answering these questions, investors can make “score cards” as they analyze exchange traded funds. This will enable them to screen ETFs like the pros do and maximize the effectiveness of their portfolio.
‘Dramatically Shrink The Universe’
Bill Roach is president of Globalt Investments, a $1.8 billion registered investment advisor that integrates quantitative, fundamental and technical analysis to construct portfolios. The firm’s flagship innovatETF strategies, which launched in early 2003, seek to reduce the impact of market volatility and minimize downside risk:
At Globalt, we’ve been building portfolios of exchange traded funds since 2002, so we have seen the ETF space grow both in terms of assets and the number of funds. Contrary to some, we believe that ETFs are very much still in their early innings and that there is still more innovation to come as the industry matures and the marketplace better understands these products. That being said, not all innovations will be right for us or for our clients.
Before we arrive at the portfolio construction phase, there are several steps we take as a team, all stemming from our conviction that asset allocation is the key to long-term performance and best addresses the fiduciary responsibility for managing client assets. Our disciplined investment process identifies outperforming asset classes and only then do we begin the process of investing in ETFs, rather than trying to select the best-performing active manager or funds.
Looking at the ETF industry as a whole, it can at first seem like there is an overwhelming amount of choice. However, since we have a very clear understanding of what we’re looking to accomplish with each exposure, we are able to dramatically shrink the universe of funds from the approximately 1,900 currently on the market to a much smaller number.
We constantly monitor the asset allocation and ETF selection in each of our portfolios. Each ETF holding is an expression of our preference for the asset class, sub-asset class and our specific view regarding what is attractive in that space, driven by our quantitative model and our analysis of qualitative considerations. When our view changes and we wish to change how we express that view through ETF selection, we screen for the available options in that space.
We focus on passive funds, meaning a fund must be a rules-based approach with no manager discretion, and eliminate those that do not meet our cost, size and liquidity requirements.
For example, many funds being brought to market in recent months seek to “slice and dice” different sectors into highly niche sub-sector exposures, introducing concentrations that do not fit with our approach. Hundreds of other ETFs are thinly traded and may only have a few million dollars in assets, which allows us to remove them from consideration given the importance we place on liquidity and tight trading spreads.
Once we’ve taken these initial steps, we then analyze the remaining funds in terms of their rules-based methodology, looking at factors like stock selection, portfolio construction and rebalancing process. From there, we look at the actual resulting portfolio holdings over time, focusing on things like individual position size, sector weights and other portfolio factor characteristics, as well as the performance of a specific fund vs. the benchmark against which we intend to use it.
Performance is just one of the things we look at. We do not look at it in the same way that we would evaluate an active manager, where we would be looking for persistent alpha. We are looking to understand if, and under what circumstances, it outperforms or underperforms. For instance, if we take a position in an ETF to hedge exposure to equities, we would not want an ETF that does not behave consistently with its benchmark during equity bear markets. Additionally, an ETF with excessive tracking error would not be considered as it would not consistently provide the desired exposure.
In particular, we seek to understand rolling returns, drawdowns and other historical data. As long-term investors, it is important for us to be able to understand how an ETF may respond to a variety of different market scenarios, an understanding that is difficult to achieve with many newer products. Once we’ve done all that, we select the fund that we believe will be the best fit for expressing our investment view.
‘Understand The Fund Holdings’
Todd Rosenbluth is director of ETF and mutual fund research for S&P Global Market Intelligence, a leading provider of financial and industry data, research, news and analytics to investment professionals, government agencies, corporations and universities worldwide. The New York City firm specializes in holdings-based ETF research.
“Past performance is not indicative of future results” is a phrase long disclosed by asset managers to clients. Investors again have been reminded of this in 2016, with many utilities and consumer-staples ETFs ranking as top U.S. equity performers year to date through July, only to decline in value in August amid concerns that bond yields could move higher as the Federal Reserve contemplates raising rates.
S&P Global thinks many investors tend to look for the largest, cheapest or best-performing ETFs without focusing on what holdings are inside. Investors need to understand the holdings inside their exchange traded fund as well as the cost structure, since these factors will be drivers of performance moving forward.
As is done with a potential individual stock investment, valuation and risk assessments should be undertaken using an ETF’s holdings to ensure that the securities inside are appealing in the current environment. While our research incorporates the full holdings, with many investors focusing on market-cap-weighted ETFs, a review of the top 10 positions can give great insight.
For example, 60% of the assets for Utilities Select Sector SPDR (XLU) are spread across its top 10 holdings. According to S&P Global Market Intelligence’s qualitative research, five of these 10 are overvalued, including Duke Energy (DUK) and Southern Company (SO), compared to just two that are undervalued; the other three are fairly valued. Meanwhile, six have below-average earnings and dividend records, which is a key risk consideration.
Consumer Staples Select Sector SPDR (XLP) is similarly concentrated in its top 10 holdings, but our research is more favorable on this ETF. Six of these stocks are undervalued to us, including Procter & Gamble (PG) and Wal-Mart (WMT), with just one of its major holdings considered overvalued. In addition, none of the top 10 constituents has a below-average earnings and dividend record.
We think XLP is a better investment given prevailing market conditions.
Investors also should consider the costs they will incur buying and selling these ETFs. Both XLU and XLP cost 14 basis points annually to hold (or $14 in annual fees for every $10,000 invested). While this is relatively cheap compared to active mutual fund alternatives, this is higher than comparable market-cap weighted ETFs from Vanguard and Fidelity.
However, the bid-ask spread, which is the difference between the price to buy and to sell the ETF, for both XLU and XLP is just $0.01. This is much narrower than its peer offerings, offsetting the higher holding costs.
While trading costs will matter less for longer-term investors, these sector equity ETFs incur significant volume and as such the costs will matter more to more tactical investors.
As the ETF universe continues to expand with similar-sounding smart-beta products focused on single or multiple factors, such as low volatility and quality, investors should look inside the funds because the sector exposures will be different, impacting performance.
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View more information: https://www.investors.com/etfs-and-funds/etfs/choosing-an-etf-for-your-portfolio-made-easy-ace-the-art-with-expert-advice/