Buying an ETF for More Than The Ticker

Courtesy of Forbes Contributor Ari Weinberg

July 30

If you invest in exchange-traded funds, you’ve probably heard about the forthcoming service from IndexUniverse.

If you really follow ETFs, you’ve probably wondered what took them so long.

Years in the making, publisher IndexUniverse is finally rolling out its own ratings and analysis service for ETFs. Currently in commercial beta for financial advisers, institutions and other professionals, ETF Analytics takes a different tack than uber, fund-rating firm Morningstar (MORN).

IndexUniverse rolls up its individual ETF analysis into both letter and number grades, while leaning on its current ETF classification system for sectors, themes, styles and more. The service is launching with evaluations on all equity-based ETFs and will eventually cover fixed income, currencies and alternatives.

But Zagat of ETFs it’s not. And, at an initial price of $3000, the service is not for the faint of heart or light of wallet.

For top-level insight on what an individual investor can glean from the new product, I sent over a few questions to Matt Hougan, President of ETF Analytics for IndexUniverse.

AW: What is the biggest or most common mistake investors make when evaluating an ETF?

MH: Just buying tickers.

We see far too many investors just buying the ETFs they are familiar with, or trusting how ETFs are marketed, without looking under the hood.

Take the iShares FTSE China 25 Index Fund (FXI). It has the bulk of the assets for ETF investing in China. But the truth is: It does a terrible job capturing China. FXI has no exposure to technology and very little exposure to consumers.  Eighty percent of the portfolio is invested in old-school, ex-government firms, with none of the entrepreneurial, middle-class-driven growth that most investors want from China.

A fund like SPDR S&P China (GXC) gives you much better exposure, but investors don’t bother to look.

AW: Should buyers differentiate between products for “traders” and “investors?”

AW: Should buyers differentiate between products for “traders” and “investors?”

MH: Absolutely.  When we built our ETF rating system, the first thing we said was: Different ETFs are right for different people. If I’m a short-term trader holding for 5 days, and you’re a long-term investor holding for 5 years, we will most likely end up in different products.

If you’re holding for 5 days, who cares about the expense ratio? Who cares about tracking error?  The difference in costs over 5 days for a fund that charges 1% versus a fund that charges 0.1% is 0.01%.  If you’re holding a fund short-term, what matters are spreads and execution costs.

Conversely, if I’m holding for 5 years, I might pay a wider spread to get into a longer-term fund. The up-front costs get spread out over your entire holding period.

That’s why we built our ratings system around 3-parts: Efficiency, Tradability and Fit.  No single rating can convey everything about an ETF.  We want traders to be able to look at our ratings and find the right fund for them; we want long-term investors to be able to look at our ratings and find the right fund; and everyone in between.

AW: Can the attributes you are evaluating in ETF Analytics be applied to traditional mutual funds, stocks or other assets?

MH: Partially.

The idea of Fit–how well does this product provide exposure to a particular area of the market–is a powerful way to approach analyzing any financial security, whether it’s an ETF, single stock or mutual fund.  Honestly, it’s the way institutions have been doing things for a while; it just hasn’t trickled down to the adviser and retail investor level.

For the last 30 years, they’ve been led down a path of chasing performance. We’re starting to see that change, as investors focus more on asset allocation and macro-economic trends. ETFs are the perfect tool for attacking this, but the concept can be applied elsewhere.

Our tradability metrics are very ETF specific, which is important. A lot of people say that ETFs “trade just like stocks,” but that’s a misnomer. Most of the reporting you see on ETF liquidity these days completely overlooks the concept of underlying liquidity, and we’ve tried to correct it.

Efficiency is a universal concept: Do funds deliver on their core promises to investors? I don’t think mutual fund investors (including index fund investors) have paid enough attention to things like tracking error in the past, but clearly, it’s applicable across the universe of investment products.

It’s important to approach these things carefully in ETFs, because they operate in areas of the market that traditional funds and stocks don’t touch (say, commodities or currencies, which have their own issues).  But the core idea holds true everywhere.

AW: When putting a portfolio of ETFs together, what are your top guidelines for picking funds?

MH: Asking yourself about E, T and F really is a good way to start, whether you use our product or not.

Efficiency: Does this fund deliver on its core promise to me, with no risk? Are the expense low? Does it track its index well? Are there hidden blow-up risks?  Funds should pass this level of scrutiny before you even begin to consider them.

Tradability: Can you buy and sell this fund at a fair price? This is just as important as expense ratios and tracking error, and too often people overlook this.

Fit: Does this give me the exposure I want?  Dig under the surface, and don’t just accept what the ETF issuers tell you.  You’ll be surprised to find that ETFs will claim to do one thing, but, in fact, are doing something different.

AW: What is different about evaluating an active ETF vs. a passive, indexed ETF?

MH: The big difference is that an active fund’s portfolio tends to change more rapidly and more randomly than an index fund.  What that means, in my mind, is that “tilts” should be viewed as a snapshot and not as a trending allocation.

Let me put that in English:  Let’s say you have an equal-weighted S&P ETF. When you compare it to the broader large-cap U.S. equity universe, you’ll see that it tilts small, it tilts towards growth, and it overweights industrials and utilities.  Those facts will generally be true one-month from now, and one month from that, and you can base your decision on whether to buy that ETF on whether or not you like those tilts.

With an active fund, who knows. The manager could have a change of heart; they could move the portfolio in an entirely different direction.  Efficiency and Tradability still work well for active products, but within the Fit section, I use the tilts data simply as a snapshot. Instead, I look at the regression data we show to see what the beta of the fund is to the broader market, what the up/down capture is, has it generated statistically significant alpha. The tilts info is still interesting, you just have to take it with a grain of salt.


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