Choosing an ETF

August 16, 2016

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.

Table1

Category and Index names

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

table2

 

table3

 

table4

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.

table5

Copyright © 2016 Douglas R. Knight


Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


Index weighting

June 17, 2012

Introduction

An index is used to measure changes in the economy or securities market.  In securities markets, the index is an imaginary portfolio of securities representing the entire market or market segment.  Each index has its own set of inclusion-exclusion criteria (filter) and calculation methodology.  The typical measure of an index is its weighted average, in which each unit of the index to be averaged is assigned a weight.  The weight determines the relative importance of the unit to the measure. The performance of an index is expressed as the percentage change of the baseline measure1,2.

Index weighting

Market-cap weighted index.  The index value is the average market capitalization of all stocks in the index (e.g., the S&P 500).  Larger companies account for a greater portion of the index3.  The main advantage of the index is its simplicity.   The main disadvantage is that the index value is heavily influenced by stocks with the largest market caps.  The index performs best when large cap stocks gain momentum and outperform smaller capitalized stocks.  Conversely, the index performs worst when large cap stocks lose momentum and underperform smaller capitalized stocks4.  Momentum bias is the dominating influence of high-momentum, overvalued stocks compared to low-momentum, undervalued stocks5.

Equal-weighted index.  The index is designed to give the same weight, or importance, to every stock in the portfolio.  The main advantages are: 1) small companies have as much weight as large companies6, and 2) the index is unaffected by momentum bias5.  The main disadvantages are: 1) equal-weighted indices tend to have higher rates of stock turnover than market-cap weighted indices and as a result, they are rebalanced more frequently6,7, and 2) equal-weighted indices are more volatile than market cap weighted indices due to the influence of small cap companies5.  The equal-weighted index is not calculated the same way as a price-weighted index6.

Fundamental-weighted index.  The fundamental-weighted index selects stocks based on weightings derived from data on company performance (e.g., sales, earnings), company value (e.g., book value), or shareholder reward (e.g., dividends)4,5.  The advantage of an index based on company performance is the lower likelihood of entrainment into a market “bubble” caused by momentum.  The disadvantages are that 1) the index is biased by a valuation of the company, and 2) the index incurs more turnover and higher expenses compared to the other indices 5.

Price-weighted index.  The index value is the average share price (e.g.,the Dow Jones Industrial Average).  Stocks with higher prices exert greater influence on index performance3,5,8.

Investment fund Index weighting risk

In a nearly 2-year time period, 77 ETFs changed their Index9. The danger to this move is a decline in Fund performance due to a change in index methodology.  For example, different Index providers who measure the same stock universe might use different weighting strategies, such as equal weighting versus weighting by market capitalization.  The change in weighting strategy would cause the ETF to reallocate its portfolio holdings, a move likely to affect fund performance.  One (questionable) reason for changing the index appears to be a purposeful change of portfolio holdings aimed at limiting tax consequences for the fund by maximizing capital losses and minimizing capital gains.

References

1.  Definition of ‘Index’  http://www.investopedia.com/terms/i/index.asp#ixzz1wqXHulOS

2.  Definition of ‘Weighted Average’:  http://www.investopedia.com/terms/w/weightedaverage.asp#ixzz1wf6hIDZG.

3.  Definition of ‘Weighted Average Market Capitalization’ http://www.investopedia.com/terms/w/wamc.asp#ixzz1wf7LAvtS.

4.  Rich White, 3 Types Of Indexing For ETF Success, November 23 2011, http://www.investopedia.com/articles/exchangetradedfunds/08/index-debate.asp#ixzz1wf9jnR9V

5.  Richard Shaw, Three Approaches to Index Weighting, September 15, 2008.  http://seekingalpha.com/article/95466-three-approaches-to-index-weighting

6.  Equal-weighted indices.  http://www.financialwebring.org/gummy-stuff/equal-weights.htm

7.  Definition of ‘Equal Weight’.  http://www.investopedia.com/terms/e/equalweight.asp#ixzz1wf7skCyn.

8.  ‘Price-Weighted Index’, http://www.investopedia.com/terms/p/priceweightedindex.asp#ixzz1wf5947Ly.  © 2012 Investopedia ULC.

9.  Weinberg, Ari I.  ETFs: Behind the fee cuts.  The Wall Street Journal, November 5, 2011.


ETF Valuation

September 24, 2011

Figure 2 (below) was obtained from the interactive chart provided by Bloomberg.com.  The chart shows price trends for 3 different valuations of SPY (SPY is the stock market’s ticker symbol for the SPDR S&P 500 ETF Trust).

  • SPYNV:IND (red) represents the S&P 500 Depository Receipts Index Net Asset Value, which measures the NAV per share of SPY
  • SPTR:IND (green) epresents the S&P United States 500 Total Return 1988, which measures the total return of 500 stocks in the S&P 500 Index in reference to 1988.
  • SPY:US (orange) represents the share price of SPY.

Fig. 2 SPY’s Index, NAV, and Price movements

In the legend above the chart, the numbers are the closing prices on 9/30/2011.  In the chart, the price movements are expressed as ‘percentage changes’ on the vertical axis in relation to ‘time’ on the horizontal axis.  The parallel behavior of the graphs provide evidence to support (1) the investment goal of the Fund, which is to match the NAV to the performance of the Index, and (2) the effectiveness of arbitrage in matching the share price to the NAV.

Fund documents report the following discrepencies between ETF valuations:

  • Discrepencies between NAV and Index performance are reported as “tracking error“.
  • Discrepencies between share price and NAV are reported as “premium(discount)“.

Copyright © 2011 Douglas R Knight


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