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Three Questions to Ask Before You Buy an ETFBy
Wednesday, August 30, 2017
A decade ago, exchange-traded funds (ETFs) were barely on investors' radars.
But since then, the ETF industry has exploded. ETFs are now the bread-and-butter tool for everyday investors looking for an easy way to invest in a particular geographic region, market, sector... you name it.
A record $3.4 trillion of assets under management (AUM) is now held in ETFs. That's a nearly 17-fold increase since 2003.
And this trend isn't slowing down anytime soon...
What's behind all this new money in ETFs?
Investors have been disappointed with the relatively high fees and underperformance of active funds (that is, funds where managers select stocks themselves). This has made ETFs – low-cost, passive funds that simply track a particular benchmark index – more attractive.
ETFs have radically democratized the investment process for everyday investors. But like everything in investing, you need to make sure you know what you're buying.
Here are three things you should consider before you buy an ETF...
1. What is the cost?
ETFs charge a fixed-percentage annual running cost to shareholders. This is known as the "expense ratio." While an actively managed fund might charge, say, 1% of AUM and a percentage of profits, ETF expense ratios are typically less than 0.50%. And expense ratios continue to decline.
However, you still need to know what's expensive and what's not...
Remember, different underlying ETF assets will affect the expense ratio. If the ETF tracks a major benchmark developed market index like the S&P 500, the expense ratio should be low.
But if it holds a wide range of emerging market stocks, expect the ratio to be higher. It's more expensive for an asset manager to replicate a basket of stocks across multiple exchanges – so the expense ratio will reflect those costs.
When I want to establish a baseline for a particular type of ETF, I check fund manager Vanguard's ETF page. Vanguard is renowned for offering the most cost-effective ETFs. It currently offers 55 ETFs across a range of underlying asset classes and sectors. So when I'm comparing costs, I use Vanguard as a starting point.
2. How is the liquidity?
Liquidity is the ease with which you can buy and sell a security in the market without affecting its underlying price.
When it comes to most individual investors, our buy and sell orders don't visibly move the market. But they can if we're looking at things like thinly traded small-cap stocks. And some ETFs can suffer from a lack of liquidity, too...
The first sign that an ETF might not be easy to trade in and out of comes from looking at its AUM. A small ETF is far likelier to suffer from low liquidity than a large multibillion-dollar fund.
The second factor to consider is the nature of the underlying securities in the ETF. If your ETF holds a basket of large-cap developed market stocks, then liquidity won't be a problem.
On the other hand, look at an ETF like the iShares Barclays USD Asia High Yield Bond Index ETF (AHYG on the Singapore Exchange). With $75 million in total assets, it's small... And it holds relatively illiquid assets (Asian high-yield bonds). In cases like these, liquidity is going to be a problem.
If you choose to buy a relatively illiquid ETF, please make sure you use a limit order. That means when you place your buy or sell order, specify the maximum purchase price (or minimum selling price) you are willing to accept.
3. How does the index work?
I can't stress this enough – when you are buying an ETF, you're not only investing in a basket of securities, but ALSO in the mechanics of how the underlying index works.
In the early days of ETF investing, this was less of a consideration. Most of the first ETFs sought to replicate standard benchmark indexes, like the S&P 500. But today, the number of indexes has exploded to around 5,000 globally... And they cover every imaginable type of investment.
Beyond all of these different sectors and themes, you can also find a growing list of "smart beta" indexes.
Most indexes simply take a basket of stocks and weigh them according to their respective market caps. But smart beta indexes use more complicated factors to choose their underlying stocks... They can account for volatility and risk, or track stocks with the most momentum, or seek out dividend payers. By doing this, smart beta indexes aim to provide investors with enhanced returns.
Smart beta indexes – and the ETFs that track them – might sound appealing. But you need to take the time to read through the index-construction documents. You can't just take the name of an ETF at face value and assume it's giving you what it says it is... Always "read the fine print" of your investments.
So if you're looking to invest in an ETF, make sure you do your homework. Read the fine print, and make sure you know exactly what you're getting into by answering these three questions first.
Good investing,
Tama Churchouse
Further Reading:
"You might expect the average mutual fund to perform about as well as the market," Porter Stansberry writes. "But that's not the case." Get the real story here: This Hidden Danger Could Be Draining Your Portfolio.
We don't often recommend hiring a financial planner... But Dave Eifrig recently offered two situations where it might make sense for you. Learn more here.
Market NotesA HUGE WINNER IN THE WORLD OF CONNECTIVITY Today, we pull back the curtain on a company you won't hear about at cocktail parties...
Boingo Wireless (WIFI) is the world's leading Wi-Fi provider. The company builds wireless networks at airports, stadiums, college campuses, military bases, and more. If you've ever connected to the free Internet at your local airport while waiting to catch a flight, there's a good chance you've done so on Boingo's network.
The company makes money through advertising, data analytics, and charging consumers to use its Wi-Fi networks. Today, it serves more than 1 billion consumers a year. And earlier this month, it announced impressive second-quarter earnings, extending its streak to 11 straight quarters of double-digit revenue growth.
As you can see from the following chart, WIFI shares have been in an impressive uptrend of late. They're up nearly 200% over the last 18 months alone, and just hit a fresh all-time high. As more folks hop online, Boingo's services will continue to be in demand...
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