Five Questions To Ask When Buying An ETF

by on April 24, 2012 | ETFs Mentioned:

The ongoing expansion of the ETF industry continues to bring previously hard-to-reach corners of the global financial market at the fingertips of mainstream investors and institutional money managers alike. However, with innovation also comes the introduction of new complexities, and for many, the towering lineup of over 1,400 exchange-traded products can seem a bit intimidating at first glance. For traders and investors alike, there is a host of obvious and many not-so-obvious factors to consider before buying into a position [see Free Report: How  To Pick The Right ETF Every Time].

Below we take a look at five important questions to ask when buying an ETF:

1. Is It An ETF?

Don’t take this question as an insult to your intelligence. The term “ETF” is notoriously used to describe a universe of inherently different products: the exchange-traded product umbrella covers exchange-traded notes (ETNs), unit investment trusts (UITs), and grantor trusts in addition to ETFs. Most are aware of the general differences between ETNs, which are debt instruments, and ETFs, which feature no credit risk but can experience tracking error. However, a surprisingly large number of investors (including many professionals) have a poor, or misleading, understanding of the underlying nuances and complexities associated with each of the various exchange-traded instruments.

It’s important to first and foremost understand the differences between the various ETPs available, because a seemingly minor difference in product structure can often times have a meaningful impact on bottom line returns  [see When Structure Matters: ETF, ETN, Or Other?].

2. What’s Under The Hood?

Asking what’s under the hood is an important question that ETF invetors and car buyers alike must remember to ask. What exactly are you looking to buy? It may seem obvious, but it’s important to have a clear cut objective in mind before going “ETF shopping” so to speak. The next step is to take a careful in-depth look at each of the available products that suit your investment objectives. For example, let’s say you’re looking for gold exposure [see Gold ETFs: Factors To Consider Before Buying]. With over a dozen gold ETFs to choose from, your next step should be a thorough look at how each of the products achieves its objective.

Investors can opt for a physically-backed gold ETF, while others may prefer the use of futures-based products; neither of these is better than the other, the point is that investors need to have a clear understanding of product’s objective and approach to achieving it, otherwise it may be wise to walk away–quickly!

3. How Frequently Does It Trade?

As with any financial instrument, liquidity is an important factor to consider before making an investment. However, looking at average daily trading volumes is only half the picture because ETFs are capable of something called “spontaneous liquidity”. As the name suggests, this unique mechanism allows for the creation of new ETF shares almost immediately, thus making it possible to execute large trades in thinly-traded funds without moving the price by a meaningful amount [see Ten Commandments Of ETF Investing].

Simply put, low volume ETFs should not be avoided because of liquidity-related fears; nonetheless, caution should certainly be exercised as wide bid-ask spreads can put you in an early hole. After you find a product that meets your liquidity criteria, make sure to use a limit order when establishing your position.

4. Are There Better Options?

The real beauty of the ETF industry is that it provides investors with the luxury of choice; with over 1,400 ETPs on the market, there is duplication in many asset classes and investment strategies, giving investors the freedom to choose. For example, investors looking for a financials equity ETF have a host of offerings to consider; while most of the ETFs in this space offer similar objectives, a number of alternatives are also worth a closer look. Investors may wish to steer clear of market-cap weighting and opt for an equal-weighted product like RYF instead, or perhaps the revenue-weighted RWW.

Just like in the real world, shopping around before buying an ETF can save you money. There are a handful of instances when doing your homework can help you cut down on expenses over the long haul. For example, Vanguard’s VWO is linked to the same emerging markets index as EEM; the difference, however, is that VWO charges a fraction of the cost of its competitor, increasing the appeal to cost-conscious investors [see Inflows Surge For Cheap ETFs].

5. How Balanced Is The Portfolio?

ETFs hold major appeal among long-term, buy-and-hold investors because of the cheap and easy diversification benefits they offer. However, not all ETFs are well diversified; in fact, it’s not uncommon for a fund to allocate over 50% of its total assets to just ten holdings. Another example is foreign equity ETFs, which are prone to a number of potentially unwanted biases. Emerging markets ETFs tend to be dominated by multinational giant and large cap stocks, which are not truly a “pure play” on the local economy; this sort of bias can effectively diminish the diversification benefits associated with international investing [see Free Report: Seven Simple And Cheap ETF Model Portfolios].

Investors need to take a good look under the hood of a product before buying into a position. It’s important to take note of any major allocations to a single stock, country, or sector as it could have a significant impact on the fund’s risk/return profile.

 

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Disclosure: No positions at time of writing.