4 things to look at before investing in an ETF

ETFs, Value investing

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I was amused to read last week in the 7/10/06 issue of Barron’s that and I have the same portfolios. We independently arrived upon very similar approaches, though it doesn’t mean much, especially since I’m not familiar with his investment philosophy or performance.

Still, you always get a little tickled if someone famous (and that accomplished, if a bit goofy) agrees with you. He claims, as I do, that he has neither the interest or temperament to invest other people’s money, and that if he ever lost a widow’s money, he’d “probably leave the country or jump off a tall building.” I’d probably do the same.

In the article, Stein advocated creating a so-called fund of funds by using ETFs and index funds, and hedging not with short plays but with cash. Maybe this isn’t that uncommon a strategy, but it turns out that we’ve picked the exact same ones in which to invest, sans Utilities (XLU) and Natural Resources (IGE). (I did own XLE briefly last year but sold it out of being conservative and trying to limit my investments in things I don’t understand. Like oil.) In the interest of full disclosure, I’ll state here that I currently own shares of EEM, EFA, and VTI, and IWN (as Ben recommends). I also have tiny holdings in EWO and EWJ (see below).

So let’s say you decide to invest in an ETF. What is it, and what should you look for?

An Exchange Traded Fund (ETF) is a type of investment vehicle that usually passively follows an index but trades on an exchange like a regular stock (unlike a mutual fund). An ETF’s setup is mind-bogglingly complex, but (knock on wood), hopefully not something the average investor must fully understand before investing in one.

PROS: ETFs make a nice alternative to many index funds because their expense ratios are comparably low, you can do more with some of them (such short-selling them, if you want to), they don’t have minimum holding periods like many mutual funds do, and they can make for an easy way to invest in a particular sector or specialty area that you might not otherwise have access to as an individual investor.

CONS: On the downside, ETFs are still a relatively new type of investment vehicle, and more and more are being introduced each day. So, depending on what you’re looking at, an ETF might have little or no track record, be illiquid (trade at low volumes) and therefore difficult to get into and out of at the price you want, and they require a certain amount of discipline if you’re using them as substitutes for mutual funds for a dollar-cost averaging investment strategy.

Why? Because in general, brokerages will often offer some selection of mutual funds that can be easily set up for investing via automatic deposits at regular intervals, and you benefit from this dollar-cost averaging by being able to buy odd-lot or fractional shares. Moreover, these buys usually come with no commission costs (but be sure to doublecheck before assuming such a thing).

In contrast, ETFs are like stocks, so it’s up to you to buy them on a regular basis and do the calculation of how many odd-lot shares to purchase each time, if you choose to dollar-cost average. (Most brokerages won’t allow you to buy fractional shares.) Depending on the amount you buy and your brokerage’s terms and conditions, it could be cheaper to buy mutual funds than ETFs, so you’ll need to compare the mutual fund’s total expense ratios against commission costs for trading ETFs. Especially if you plan on reinvesting dividends and capital gains. Or, the convenience of buying a mutual fund instead of relying on self-discipline might be worth it.

Back to ETFs. Let’s say you’re interested in buying one. What should you do? Here are my recommendations:

1. Use Yahoo! Financials or some other online service to get quick stats about the fund. I put this first because my approach is to narrow down potential investment candidates, and this is one quick way to do it. There might be a few ETFs to choose from. For example, a search on “energy” on Yahoo’s ETF search reveals four choices. Which is best? Do you want to invest in global energy, or just US and Canada? Also, I tend to avoid illiquid stocks, so I use this quick step to make sure the ETF is purchaseable. Turns out the only one that liquid enough in my book is XLE, but you might prefer another.

2. Ignore the name of the fund. What are its holdings? One of the pitfalls of ETF investing is to assume that because you’ve bought a bunch of ETFs, you must be diversified. This is patently untrue. Let’s take EEM. The name of this ETF is “Diversified Emerging Markets”. Sounds great! But check its current holdings to determine what you own. Last year, their top holding was Samsung, and all of their top 10 holdings were in Asia. If you thought you were getting exposure into Latin America and Russia, you had to think again. It’s also possible that your holdings might all be in one sector, such as Financials or Technology. Bottom line: always check what you’re really buying and figure out how it fits into the rest of your portfolio.

3. How has the fund been performing in comparison to other investments? Of course, past performance is no indication of the future, but what you’re doing here is trying to make sure that you don’t have blinders on. In many cases, if there’s an ETF, there’s at least a mutual fund to match, or a closed-end fund. And it could be that an actively well-managed fund outperforms a passive investment, especially in the emerging markets.

Let’s look at Japan. Japan has an ETF in the form of EWJ. It’s done well, but there are mutual funds and a closed-end fund also focusing on Japan, symbol JEQ. Sometimes a closed-end fund will outperform an open-end fund (such as an ETF or mutual fund) because it’s less well-known, or perhaps it flat out has different holdings, and sometimes it won’t. Closed-end funds tend to have higher expense ratios, but sometimes their performance can outweigh those fees. I owned JEQ last year and then moved over to EWJ because it was more liquid. Here’s a two-year chart comparing the two funds’ performance.

Or EWO (Austria ETF, which serves as sort of a proxy for investing in Eastern Europe) versus EUROX (actively managed Eastern European fund). The point is to look at all your choices before putting down money, just as you’d do before you bought a car.

4. Read the fund’s prospectus You knew this had to show up sooner or later. It’s a pain, but why not get the fund’s information and performance straight from the horse’s mouth? Here, fund managers have to disclose their best and worst performing quarters, their investment strategy, expenses, total asset turnover, etc. I’ve written about the recently already, so I’ll save my breath here.

Well, this article is long enough. But I’m sure savvier investors out there will have more to contribute or add. How ’bout it?


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11 Feedbacks on "4 things to look at before investing in an ETF"


Great article.

Using the Investopedia Simulator, I created an all ETF Index portfolio. Here are my respective holdings and the approx. % of the portfolio they comprise:

Vanguard Value (VTV) 20%
Vanguard Growth (VUG) 20%
Vanguard Extended Market (VXF) 15%
Vanguard Dividend Appreciation (VIG) 10%
Vanguard REIT (VNQ) 5%
Vanguard Pacific (VPL) 10%
Vanguard Emerging Markets (VWO) 10%
Vanguard Europe (VGK) 10%

Nothing sexy, but basically covers every aspect of the market. I hold similar holdings in my actual portfolio, but I chose mutual funds over ETFs (commission costs are too prohibitive for using ETFs on a regular basis).

Carnival of the Capitalists » Names@Work » Blog Archive

[…] Four Things To Look At Before Investing in an ETF Ricemutt from Experiments in Finance looks at the pros and cons of ETFs and how to read them for their real value. […]


The article is great with all basic things needed to learn about ETF.



Thanks, glad you liked it and found it useful.

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[…] Experiglot’s valuation In July, Experiglot’s NPV grew to $89.93. Traffic has continued to grow, albeit a bit slower, in large part due to my guest writing stint over at All Things Financial and having my post on ETFs picked up by TheStreet.com. […]

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[…] Ricemutt at Experiments in Finance wrote about exchange-traded funds (ETFs) last summer, offering 4 things to look for before investing in an ETF. The advice here is great for investing in any mutual fund. […]

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[…] 4 Things to Look at Before Investing in an ETF – great article on investing in ETFs. I very much agree with his point #2 – you need to check the underlying holdings of the ETF – some small ETFs have large weightings to individual stocks which can really drive the performance of the ETF. I would also add that you should look at whether the ETF is trading at a premium or discount to the underlying net asset value (NAV). While any premium or discount is usually very small for most ETFs, sometimes it can be large for illiquid ETFs. In this case, buying ETFs that are trading at a substantial premium to their NAV may not be a wise decision. […]

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