This week I received a survey from ETF.com that asked a number of questions concerning how I go about selecting an exchange-traded fund (ETF).
The survey asked about both qualitative and quantitative factors ranging from issuer brand recognition to fees, liquidity, assets under management, and index construction. It even took this one step further into how I evaluate when it’s safe to dip a toe in the water of a newly released ETF.
This process made me think hard about the most (and least) important factors to consider when selecting an ETF among the 1,700+ products currently available in the marketplace.
While each investor is going to have a slightly different take on this based on their experience and objectives, I believe that there is one characteristic of an ETF that should take precedent above all others.
ETF Index Construction
The number one quality that is going to set an ETF apart from its peers is its index construction (passive) or portfolio strategy (active).
We can sit here and debate all day about costs and platform and liquidity, but the biggest determination in historical and future performance will be the makeup of the underlying holdings.
If you question this thesis, check out the analysis I did last month that compares the returns of the PowerShares S&P 500 High Beta Portfolio (SPHB) and PowerShares S&P 500 Low Volatility Portfolio (SPLV).
The same theory proves true for a fixed-income strategy as well.
ETF providers are becoming increasingly complex in how they dice up their indices. There continues to be a migration away from stodgy market cap weighting towards more sophisticated methodologies that include fundamental or smart screening criteria.
Think about how many ETFs now focus on dividends, low volatility, currency hedging, balance sheet characteristics, and other factors. There are even multi-factor screens that use a two-part structure to narrow down a particular subset of stocks and then use a secondary ranking system to weight the underlying components.
Because of the crowded landscape, the trend has begun to run towards more concentrated portfolios with fewer numbers of holdings (< 100) in order to differentiate from a benchmark such as the S&P 500 (SPY). Of course that is also going to lead to periods of strong outperformance and affiliated stretches of subpar returns.
This concept also has a broader implication with how you shape your overall portfolio asset allocation. Like a well-built home, it’s important to focus on how the individual components of your portfolio are weighted in order to provide a solid foundation to achieve your goals. A balanced portfolio relies on non-correlated asset classes and diversification to help reduce risk and enhance long-term success.
The Bottom Line
The bottom line is that holding the right mix of stocks or bonds in a specific environment will always be able to overcome a differential in fees, trading slippage, brand affiliation, or other exogenous factors. It’s not always easy to foresee ahead of time which specific index or strategy will provide the best results.
However, it’s worth spending the extra effort to carefully compare the underlying holdings of several ETFs within a specific market segment in order to determine which one best aligns with your philosophy or current outlook.
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