5 Different Ways To Filter ETF’s

By: Pete
Date posted: 01.22.2012 (9:29 pm) | Write a Comment  (0 Comments)

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While we did suggest a few different sample ETF portfolios, there are certainly chances that you will want to have different ETF’s in your own and there are a variety of reasons why that would be the case. In fact, even if you do end up using one of those, you would probably be much better off understanding ETF’s, how to judge and choose them, etc. There are many different things that you should look for when judging an ETF, here are a few:

#1-ETF objectives: You can generally get a summary from the issuer’s website or get more details by looking at documents like a prospectus. The main thing is that ETF’s that look similar can behave very differently. For example, an ETF that tracks gold could:

-Be buying gold company stocks
-Be buying gold futures
-Be buying physical gold

In each case, the result would be different. It’s critical for you to understand what the purpose of the ETF is.

#2-The Issuer: Companies like iShares and Vanguard have very solid track records, solid balance sheets and are backed, etc. That is a good thing but it’s also a good idea to not have all of your assets with one issuer, just in case. You can use 3 or 4 of them and get products that are as efficient.

#3-Volume and Spreads: Buying an ETF also means that at some point you will be selling right? Any trade involves a cost that is more than your commission. One part is the NAV discount or premium. If an ETF is worth $10.00 and you are buying it for $10.03 on the market, that $0.03 is a “loss”. In general, higher volume in an ETF also means that the bid-ask spread is smaller. That will result in a much smaller cost when you trade in and out of the ETF. It’s not always the case but it’s a good general rule. Another method would be to look at given points of the day how wide the spread is. Anything above $0.02-$0.03 is not a great sign.

#4-Fees: This is an obvious one. For example, when looking at 2 of the biggest US ETF’s that both track the MSCI Emerging Markets; VWO (from Vanguard) and EEM (from iShares) you would notice that the main difference between the two is the much smalleer fees on VWO. That explains why EEM which used to be 10 times bigger than VWO is now actually smaller. There is no reason to pay additional fees for a similar ETF if spreads and other terms are acceptable.

#5-Tracking Error: In general, I would say that you always want to own ETF’s that have little tracking error. Even if that tracking error is positive, it is generally not a great sign for a passively managed ETF to have tracking error. One big thing to look for though is which index the ETF tracks. When tracking public indexes such as the S&P500 index, the tracking error result will be meaningful. However, some ETF’s track a custom made index and in that case, the result could be more difficult to interpret.

There you have it, 5 different things you should be looking for when buying an ETF. It is not a perfect guide but I think that any ETF that does well on these would be a good addition to your own portfolio (provided it is part of your asset allocation target of course!).

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