Picking ETFs: The Good, The Bad and The Ugly

In the mid 1990s, exchange-traded funds came riding down Wall Street like Clint Eastwood in an old spaghetti western—fearless and ready to take on the bandits who had been terrorizing the townsfolk. For years prior to the arrival of ETFs, average investors were held hostage by obscene fees while mutual fund robbers brashly collected their booty, threw back some expensive whiskey, and then shamelessly shot up the town.

In 1989 the first ETF—Index Participation Shares—came to the rescue. This S&P 500 proxy traded on the American Stock Exchange but was quickly gunned down by the Chicago Mercantile Exchange who quickly perceived the threat. It wasn’t until 1993 that the real gunslinger rode into town and changed the order of the fund industry forever.

The Good ETFs. In 1993, SPDR S&P 500 (symbol SPY) was launched on the New York Stock Exchange. Known as SPDRs or “Spiders,” the fund became the largest ETF in the world. In just over 15 years, there are now close to 1000 ETFs with more than $1 trillion in assets and growing at a breakneck pace close to 30 percent year-over-year.

But just when ETFs were winning the day, the ETF industry drifted from its sound mooring after the SEC approved a redefinition of the term “index” in 2003. Before then, ETFs were limited to holding baskets of stocks that tracked broad market indices such as the S&P 500 or MSCI EAFE for foreign developed country markets. After 2003, the SEC allowed ETF providers to create any set of guiding rules to form newfangled “indices.” This changed the definition of an index and allowed the Wall Street crowd to run wild creating the latest, greatest “index” de jour, cluttering the universe of good ETFs with a never-ending wave of convoluted, bad, and in some cases, downright ugly ETFs.

When trying to make sense of the world of ETFs, there are five simple principles that will guide you to the good and away from the bad and ugly:

• Index construction. Evaluate each ETF for the quality of the index it tracks and how well the provider replicates the given index’s performance over a long period of time. A bad index means a bad ETF.
• Low management fees. Be sure that you are paying rational management fees for the asset class under consideration. In general, the lower your fee the more you stand to make over time.
• High volumes. Quality ETFs often average billions of dollars in net assets where daily volume runs very high. This affords sufficient volume and liquidity so that the bid/ask spreads are narrow.
• Low turnover. More turnover means more taxable income. Look for turnover to be very low, about 10 percent for equity ETFs. Turnover is generally greater for bond ETFs because bonds mature and need to be continually replaced.
• Quality sponsors. Look to Vanguard, iShares, SPDRs, and Schwab ETFs for quality funds. These four firms account for close to 90 percent of all ETF assets and are highly regarded in the industry. Since Vanguard is a not-for-profit institution with the lowest fees in the industry, they tend to keep the other ETF providers “honest.”

The bad and the ugly ETFs. With new indexes popping up daily, the original “purity” of ETFs as suitable building blocks for asset allocation has been polluted. One of the most extreme examples of this is an ETF released in 2007 (now closed) by FocusShares, which developed an index of mid- and large-sized companies consisting of casinos, producers of beer and malt liquors, distillers, vintners, as well as cigarette manufacturers, and called it a “sin” index. Below is a list of potentially bad and ugly ETF categories to watch out for:

• Leveraged ETFs. While ProShares launched the first leveraged ETFs, a subsequent wave of leveraged products have followed. Strangely, these leveraged products have been known to sometimes severely miss the index over the long haul. Because daily returns are compounded, the returns of leveraged ETFs over periods longer than one day will likely differ in amount. And leverage is dangerous. Take for instance Direxion Daily Financial Bear 3X Shares (symbol FAZ), which plunged 95 percent, earning it the ignominious title of worst performing ETF in 2009.
• Actively-managed ETFs. It has been said that “if you can’t beat ’em, join ’em.” Well this seems to be the case with many active money managers that are now moving their practices from the mutual fund industry over to the ETF space. ETFs with a portfolio manager face the same challenges that mutual funds face—high fees and poor long-term performance records.
• Commodity ETFs. These hold futures contracts. Avoid ETFs that buy future contracts to achieve commodity exposure. Futures-based funds can fail to track their target index and are vulnerable to problems such as contango and backwardation. It is best to avoid such ETFs and stick with commodity ETFs that actually hold the underlying assets.

For you investment geeks who want a more comprehensive discussion on how we’ve used this to pick the ETFs for our MarketRiders portfolios, click here. When it comes to ETFs, invest in the good and avoid the bad and ugly. As tempting as the newfangled ETFs can be, the details reveal serious investment risks. By sticking with the five principles to finding good ETFs you can invest with confidence knowing that you have kept the bandit out of your portfolio.