How To Identify A Good ETFby@DataGeneralist
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How To Identify A Good ETF

by Steven FinkelsteinMay 27th, 2022
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Choosing ETFs for your portfolio requires establishing an objective, deciding how active you want to be, and looking at the ETFs' liquidity, holdings, expense ratio, and objective.

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The exchange-traded fund, or ETF, has become such as successful vehicle for investing that there is likely one for any situation you can dream of. From countries with economic freedom (FRDM) to the metaverse (META), you might be paralyzed by the abundance of choices. How can you make sure to choose the appropriate ETFs for your portfolio?

Where Do I Find Good ETFs?

When searching for ETFs, it’s best to first narrow it down with a specific type of objective in mind. Are you looking for a specific region (e.g. China, Europe, Emerging Markets, Domestic)? Are you looking for specific company size (e.g. large-cap, mid, small, micro)? Are you looking for certain themes, commodities, or sectors (e.g. technology, semiconductors, energy, gold)? I would suggest searching via Google rather than your brokerage because the latter will bias results in their favor. The ETF Database is a popular website that displays a wide selection of ETFs. If you are looking for other options, I would suggest googling “ETF Screener“.

If you are not finding what you are looking for, here is a list of some ETF providers that I have encountered over the past few years.

  • Ark
  • Blackrock
  • Cambria Funds
  • Charles Schwab
  • Direxion
  • Fidelity/iShares
  • Invesco
  • JP Morgan
  • Roundhill
  • Simplify
  • State Street
  • Vanguard
  • Wisdomtree

Where Will This ETF Fit In My Portfolio?

Most investors, myself included, preach diversification of assets within a portfolio. If you adhere to this advice, then you need to establish where this ETF will fit in with your existing assets. This first step is establishing your objective for the ETF. Some key questions to ask yourself are whether this ETF will be:

  • Short term/Tactical vs. Long term/Core holding?

  • Held in a taxable vs. non-taxable account?

  • Domestic vs. International Developed vs. Emerging Markets stocks?

  • High vs. Medium vs. Low dividend/shareholder yield (i.e. value vs. growth stocks)?

  • Large cap vs. Mid/Small Cap vs. Diversified cap size?

  • One sector/industry vs. Diversified sectors/industries?

What Does This ETF Contain?

ETFs typically contain a basket of stocks or bonds; however, some will include other types of assets (e.g. commodities, crypto exposure, etc.). Using the Vanguard Total Stock Market (VTI) as an example, we can locate their documentation to further understand what is in this ETF. Within this documentation, the assets being held are often described in the “Objective”, “Overview”, “Portfilo and Management” and “Holdings” sections. Within the documentation, you can find out the following characteristics of VTI:

  • “Seeks to track the performance of the CRSP US Total Market Index.”

  • “Large-, mid-, and small-cap equity diversified across growth and value styles.”

  • Top 10 holdings include Apple, Microsoft, Alphabet, Amazon, etc.

  • 27.6 percent is in the technology sector

  • 1.37 percent shareholder yield

This information informs you that this is a diversified portfolio of U.S.-based stocks across all industries and sizes. If you want more details you could dive deeper into the market index that this ETF tracks. ETFs that track an index are “passively managed” (i.e. less active) than ones that are actively managed (e.g. ARKK fund). The active managed ones tend to change holdings more frequently and are often more expensive than the passively managed funds.

With a shareholder yield of 1.37 percent (i.e. blend of value and growth), shareholders can expect a return of this amount of money for each share. Shareholder yield refers to buybacks, debt paydowns, and dividends, while dividend yield only refers to dividends. Value companies tend to have higher shareholder yields and return more cash back to the shareholder, while growth companies tend to reinvest their earnings back into the company.

The objective of the fund is not something to be taken lightly. Because of the popularity of ETFs, there are many available that are more complex than your traditional index fund. If a fund factsheet mentions words such as “leverage”, “covered calls”, “managed futures”, “hedge”, “options wrapper”, or other advanced financial terminology, then you should probably avoid it unless you have a solid grasp or seek a financial professional’s opinion.

How Active Do You Want To Be?

Choosing ETFs that are more tactical require a pre-determined exit plan as opposed to the long term plays which you can HODL. There is a range of how active you need to be with each ETF. While leveraged ETFs are typically held less than year, target date funds could be held for your entire life. In general, ETFs designed to be core holdings in a portfolio (e.g. SPY, VEA, AGG) can be left alone for decades if the investor chooses to do so.

How Liquid Is The ETF?

Liquidity can be defined as the ease in which you can buy or sell the ETF (i.e. swap it with cash or for cash). While most funds are easy to buy via clicking a button, the level of liquidity will determine how much it costs to move in and out of these funds. Increased liquidity means it will be quicker and easier to buy the fund at a fair price. Lower liquidity will increase volatility in prices for those funds.

There are three methods I use to understand the liquidity of an ETF: Spreads, Assets Under Management (AUM), and Volume. The bid-ask spread for a fund is the difference in the price that someone is willing to pay (the bid) versus the price where someone is willing to sell (the offer or ask). Whether the brokerage displays the bid-ask spread for a fund or not, these still exist under the hood. Brokerages like Robinhood opt for simplicity so they hide this detail, while traditional finance firms like Fidelity will display the information to the investor. A smaller spread (or difference) between the bid and ask means higher liquidity. Take a look at a few ETFs below to see how much this spread can vary from the most liquid (SPY) to the least liquid (TRTY) of the bunch.

Another indirect method of determining liquidity is to identify how many assets are under management for that fund or the volume (i.e. activity) for the fund. The more popular funds tend to have higher AUM’s and volume, which correlates with higher liquidity. You can often find the AUM and volume for a fund in ETF screeners (see below).

Source: ETFDB

Note: A more advanced statistic related to fund performance and standard deviation is sharpe ratio. Higher standard deviation means higher volatility, which is a tough thing to stomach in real time.

How Expensive Is This ETF?

The expense ratio of a fund is the managerial cost for holding this fund. If the fund appreciates 5%, you will realize a gain of <5% because of this fee*. This fee is incredibly important because many of the funds you encounter are virtually identical. It would be akin to choosing between a white sedan and an off-white sedan where the latter is priced 5,000 dollars higher for no reason.

Investing newbies, like myself in 2017, will often make their ETF selections solely based off of ETF expense ratios, and the managerial cost of holding the fund. While this is an incredibly important box to check off, it is not the sole consideration.

When comparing funds that seem similar, it might be beneficial to see how correlated the funds are. If two funds have 95 percent correlation, or higher, over several years then you likely can choose the cheaper fund. The process for checking correlations is fairly simple. First, go to a website that calculates the correlation between two funds like this one. Then, enter two funds that you want to compare, such as the Schwab U.S. Small-Cap ETF (SCHA) and Vanguard Small-Cap Value ETF (VBR). I edited the dates to show a longer time period, going back to 2010. Over the past 12 years, these funds had a correlation of 0.98. Additionally, they had very similar monthly and annual standard deviations. Because they are strongly correlated and had similar standard deviations, then it likely will not matter which one you pick. Below, you will see a chart of their performance over time and their correlation results.

Source: Koyfin

Source: Portfolio Visualizer

*There are some exceptions, such as the zero-fee funds offered by Fidelity.

Applying The Process

As you go through this fund selection process, there are many fantastic, free resources out there. Some of my favorite resources that I use frequently include the following:

Thankfully, the cost of buying or selling funds is free or nearly free on most platforms. Therefore, it is easy enough to update your portfolio as you learn more over time. This framework should enable you to have a better understanding of the differences between various funds. Some logical next steps would be improving your understanding of sharpe ratios, risk, and modern portfolio theory in order to build your ideal portfolio.

~ The Data Generalist

Financial Disclosure: Anything on this website is not financial advice.