Many investors compare exchange-traded funds (ETFs) by looking at recent returns. While this seems to be a logical approach on the surface, choosing an investment based purely on price momentum is rarely a reliable approach to maximizing risk-adjusted returns. There are many other risk factors that are important for investors to consider in order to ensure that the investment is suitable for their portfolio and the returns are sustainable.
In this article, we will take a look at why investors should look beyond ETF returns when comparing investment opportunities in order to maximize their returns.
Don’t Ignore the Risks
The vast majority of individual investors tend to focus on a potential investment’s return as the single most important factor. While returns are easy to spot on a chart, common risk indicators like alpha, beta, r-squared, standard deviation, and the Sharpe Ratio are rarely understood. Investors should seek out the greatest risk-adjusted returns when evaluating ETFs and other assets rather than simply choosing the assets with the best returns.
There are many different types of risk factors to consider:
- Liquidity Risk – Liquidity risk is the risk of being unable to buy and sell an ETF without significantly influencing the price. These risks are most pronounced in niche ETFs that are thinly traded. Investors should look at average daily trading volume (and dollar volume) to determine if liquidity is sufficient for their needs.
- Volatility – Volatility is simply the variation in an ETF’s price over time due to a wide variety of factors. For example, a bond ETF will likely experience significantly less volatility than a technology equity ETF due to the nature of their holdings.
- Concentration Risks – Concentration risks are diversification-related risks stemming from a concentrated number of holdings. For example, an ETF may hold relatively few equities or a large number of similar equities that provide little diversification – a technique that can decrease risk-adjusted returns.
Getting the Complete Picture
The performance of an ETF doesn’t reflect the complete picture of the benefits to an investor over time. While total returns may be the best measure for investors to consider, it isn’t the only measure that investors should consider when making a decision. There are other factors that influence the total amount that an investor gains or loses at the end of the day that can influence decision-making between various options.
There are two important income and expense considerations:
- Expense Ratios – Expense ratios are the amount that an ETF manager charges for maintaining a portfolio and can vary widely between funds. Oftentimes, the most popular funds have the lowest ratios, while niche ETFs may have higher expenses if they’re actively rather than passively managed.
- Dividend Income – Many ETFs pay a dividend since they own such a large number of companies in their portfolios. The impact of these dividends isn’t always accounted for in the fund’s reported returns, which means that investors should ensure they factor in these dividends when comparing different funds – especially if they value income.
Measuring These Factors
Investors can easily compare ETFs using research tools. For instance, ETFdb.com provides real-time ratings that compare all ETFs based on all these factors. An overall rating provides an idea of how the ETF compares to others in its class, which can be helpful in evaluating the best options. Investors concerned with specific items, like dividends, can also find which ETFs offer the greatest yields.
The Bottom Line
In the end, investors should look beyond total returns when evaluating ETFs. Different types of risks, as well as expense ratios and dividend income, should be considered in order to maximize risk-adjusted returns.
