Small Trades Journal

Investing in an exchange-traded fund (ETF) begins with screening many funds to identify a few candidates, then rating the candidates. My preferred open-source screeners are XTF.com and ETF.com, both of which have inclusion criteria for selecting desirable ETFs and exclusion criteria for rejecting undesirable ETFs.  Aim to find a reputable low-cost ETF that best matches the performance of its category.

Asset class

Assets are potential sources of income to investors.  Consequently, an asset class is a group of assets that earn income the same way.  The ETF portfolio holds assets consistent with the fund’s investment strategy, which is either to copy a market index by process of passive management or compete with a market index by process of active management. The index measures the performance of an asset market.

Competing ETFs are typically grouped in one of the following asset classes:

1. EQUITY is a share of ownership claimed through the purchase of a company’s stock. Equity ETFs earn capital gains and dividends from stocks.
2. REIT.  The real estate investment trust (REIT) is a company that owns and manages income-producing real estate. The REIT earns money from rent, mortgage interest, or other real estate investments. At least 90% of the REIT’s taxable income must be given to shareholders in the form of dividends. REIT ETFs earn capital gains and dividends from REITs.
3. FIXED INCOME securities pay an expected amount of interest (e.g., bonds) or dividends (e.g., preferred stock).
4. COMMODITIES are raw materials sold in markets for use in making finished products. Commodities are sold for cash or traded in futures contracts.
5. CURRENCY is a system of money in the form of cash or notes. The currency market trades different currencies to profit from trading fees and differences in interest rates.

Inclusions

The following inclusion criteria direct the search for reputable candidate funds desired by most individual investors:

1. Passively managed ETFs typically charge lower fees than actively managed ETFs and likely outperform actively managed funds over long time-periods.
2. U.S. listed ETFs comply with SEC regulations, U.S. stock exchange rules, and the U.S. tax code.
3. One of these Asset classes: Equity (stocks), REIT (real estate), or Fixed Income (bonds).

Refine your inclusion criteria by selecting reputable indices and desired market categories.

Exclusions

The following criteria should be excluded by all but the most adventurous investors!

1. Exchange-traded notes (ETNs) are not ETFs.
2. Closed-end funds (CEFs) are not ETFs.
3. Leverage and inverse ETFs are very tricky investments.
4. Actively managed ETFs charge higher fees in order to create porfolios that outperform or underperform a market index.
5. These asset classes:
   Alternatives (imitation hedge funds)
   Asset Allocation (actively managed mix of assets)
   Multi-Asset/Hybrid (diversified asset classes)
   Volatility (exposure to volatile market)
   Commodities (potential tax burdens)
   Currency (potential tax burdens)

Reputable index

All ETFs compete on the basis of an Index they use to design an investment portfolio. Some Indices make better measurements of market performance than others. Beware that some Indices measure untested markets. Generally speaking, the best-in-class ETFs use reputable market indices. One way of choosing a reputable index is by selecting a long-standing, oft-quoted Index provider or Index name.

Index providers are companies that specialize in measuring market performance and selling the information to financial institutions. Table 1 provides a sample of reputable Index providers.

Category and Index names

Asset Classes have unique categories. Each category may be measured in a variety of indices listed in Tables 2-4.

Rating the candidates

By now you should have several ETFs that could satisfy your investment goal. Verify that they belong to the same category, then assess their suitability based on the following critera:

1. Net assets, Total assets, Assets Under Management (AUM), or Market cap AT LEAST $1 BILLION.
2. Inception date AT LEAST 5 YEARS AGO
3. Expense ratio BELOW 1%, LOWER IS BETTER AMONG COMPETITORS
4. Legal structure PREFERABLY “OEIC” OR “UIT” (table 5)
5. Number of holdings CONSISTENT WITH THE MARKET INDEX.
6. Tracking error, LOWER IS BETTER AMONG COMPETITORS
7. Premium (Discount), LOWER IS BETTER AMONG COMPETITORS

The finishing touch

It’s a good idea to review the Annual Report of your selected ETF.  Your potential tax burden is determined by the ETF’s legal structure, its portfolio turnover, and your tax accountant’s hourly fees.

Copyright © 2016 Douglas R. Knight