ETF

Know your ETFs! Your due diligence checklist

ETFs have democratised investing for the main street investors. From plain-vanilla broad market ETFs to triple-leverage bull/bear ETFs, there is something for everyone who wants to take on a very specific exposure.

Unlike most mutual funds which may have a ‘privilege’ share class for the institution investors, ETFs have no such settings. It is a level playing field for everyone, from big-shot investors and traders who can move the markets with their trades, to the main street investors.

Double-edge sword?

For the retail investors, it is akin to a kid stepping into a candy store. The world is your oyster. However, it may not necessarily be a good thing for the retail investors especially when it comes to long term investing. Your investments should be boring but the world of ETFs is anything but boring. If you are not disciplined enough, you can get carried away with ETFs.

In this article, I will lay out a high-level checklist on the necessary due diligence for you to conduct before you invest in any ETFs.

ETFs – Active or Passive?

For the most part, ETFs are often associated with passive investing, i.e. the ETF is mandated to track a market-cap weighted benchmark. However, for the past couple of years, there has been a rising trend of smart-beta ETFs, in other words, active ETFs. Active ETFs can either be actively managed or mandated to track a ‘smart’ benchmark. Actively managed ETFs, similar to active mutual funds, are ETFs where the fund managers will proactively select the securities that form the ETFs.

Whereas active ETFs that are mandated to track ‘smart’ benchmarks typically do not have a fund manager that will select the securities that form the ETFs. Instead, the benchmark is an important consideration here. The ‘smart’ benchmarks are incorporated with investment factors that will be oriented around investment themes that may or may not produce alpha.

Such active ETFs that track ‘smart’ benchmarks are known as smart-beta ETFs.

The ultimate objective of active investing is to produce alpha.

For more information on smart-beta ETFs, see: Should smart-beta ETFs have a spot in your investment portfolio?

Deciding which strategy to adopt (Active vs Passive) is a matter of your investment philosophy. While active funds are here to stay, the returns from active funds as a whole, are a tad disappointing considering the fees that they charge.

For more information on active fund managers’ performance, see: SPIVA: Doomsday for active fund managers?

Domicile & Tax Treatment

If you are a Singapore resident, you might want to pay a bit more attention to this. For ETFs that are listed/domiciled in the US, you are subjected to a 30% dividend withholding tax. What this means is that for every dollar in gross dividends that is declared from a US-domiciled fund, you will only receive 70 cents. The rest of it (30 cents) goes to Uncle Sam.

The above does not include any charges that your brokerage platform may impose on you for the fund’s corporate action. Some platforms charge dividend handling fees.

Irish domiciled ETFs that are traded in UK exchanges, the rate is 15%, and Hong Kong domiciled ETFs that are traded on HKEX, the rate is 0%. You will find similar ETFs that are listed on all the three countries listed above. For example, in the UK, US and HK, there are S&P 500 ETFs trading in these countries. While there are some nuances in each of the ETF in these countries, these ETFs practically offer the same exposure.

Among the countries, the key differences between the S&P 500 ETFs are as follows:

  1. Tax treatment on dividend received and capital gain
  2. Total expense ratio
  3. Trading volume
  4. Trading hours

See below for a list of S&P 500 ETFs from the UK, US and HK. Note that the list below is not exhaustive.

Investment Objective 

For obvious reason, you want to know what you are investing in, i.e. what is the fund objective. Different ETFs serve different investment objectives and for better or worse, there are ETFs in the market that cater to our wildest imaginations.

Large-cap, small-cap, technology ETF (i.e. sector-based ETFs), leveraged, gaming, emerging market, value, growth, shipping, marijuana, IPO. And the list goes on and on. The ETF industry is a hotbed for financial ingenuity and innovation. While financial creativity is good for the business, is it good for the retail investors?

For the enterprising retail investors with spare time and dime, yes.

For the mom-and-pop investors, broad-market ETFs form the building blocks of your portfolio and are the core foundation of your investment portfolio. The core foundation of your portfolio is more important than the fancy funds that specialize in a sector or engage in a hot strategy at that point in time. Also, these broad-market ETFs are market-cap weighted. Any type of weighting methodologies outside of market-cap-weighted are considered smart-beta.

For more information on market-cap-weighted methodology, see: https://www.investopedia.com/terms/c/capitalizationweightedindex.asp

Having said that, there is a speculative side to everyone, allocating 5% to 10% of your portfolio to funds that are ‘unconventional’, will not do any ‘serious’ harm to your portfolio. So have fun, do your research and fingers crossed!!!

Know your Factors

If you are going to be investing in smart-beta ETFs which essentially is active investing, note that fund issuers have differing views on the sub-factors that explain the factor proposition. For example, the value proposition. Different fund issuers may look at different financial metrics to explain the value proposition. Therefore, the performance of the value ETFs from the different fund issuers can differ significantly.

For more information, see: Should smart-beta ETFs have a spot in your investment portfolio?

Value ETFs Performance

Performance

Past performance is not indicative of future performance and in this section, I am not talking about the fund’s performance per se.

Instead, for index-tracking ETFs, we should judge the fund’s ability to track its index/benchmark. This ability is known as the tracking error.

Tracking error measures the price divergence of the fund and its index/benchmark. If the fund is efficient at tracking the index/benchmark, the tracking error will be minimal. 

If you are investing in a plain-vanilla broad-market ETF that has a significant tracking error compared to its peers tracking the same benchmark, it’s probably time to relook and reevaluate your holdings.

For more information on tracking error, see: https://www.investopedia.com/terms/t/trackingerror.asp

Liquidity

Liquidity is the ease of conversion from cash to securities and vice versa.

ETFs are traded on an exchange and therefore the ETF’s liquidity is going to be another consideration factor before you execute any trade. In general, ETFs with huge asset base will have higher trading volume and hence are more liquid, as compared to funds with smaller asset base. Most broad-market ETFs are very liquid and investors should not have an issue with fluctuating bid-ask spreads in normal market conditions.

ETFs that are illiquid, i.e. thin trading volume, will have higher and fluctuating bid-ask spreads and this will translate to higher trading costs.

For more information on liquidity, see: The creation and redemption mechanism of ETFs!

Costs ~ Total Expense Ratio

Costs matter.

You have absolutely no control over how the economy will perform in the future. However, if there is one aspect of investing that you as an investor can control, will be the cost of investing, i.e. total expense ratio (TER).

Total expense ratio (TER) is the total operating cost of managing a fund. If you invest $10,000 into a fund that has a TER of 0.03% p.a., it means that you are paying $3 to own the fund annually, excluding the trading cost of buying the fund.

For more information on how costs impact the performance of your funds, see: https://www.morningstar.com/articles/740544/the-cost-matters-hypothesis

ETFs allow investors to own financial assets in a cost-effective manner. For example, much thanks to the intense competition between major fund issuers such as Vanguard, Blackrock and State Street, most broad-market ETFs have a TER of less than 0.10% p.a., excluding trading costs.

Furthermore, active strategies packaged into the ETF wrappers are more cost-effective (i.e. cheaper) than the traditional mutual fund wrapper. For investors looking for active strategies, ETFs offer a more attractive proposition than mutual funds from a cost perspective.

Securities Lending 

Securities lending helps the ETF to offset some of the cost of managing the fund and potentially allows you to invest for ‘free’. Not all ETFs conduct securities lending and for good reasons.

Knowing that your ETFs conduct securities lending assures you that the funds are broadening their revenue stream to lower the operational cost of managing the fund, which benefits you as an investor, in the form of lower TER.

For more information on how securities lending allows you to invest for free, check out: Investing for ‘free’ and Securities Lending

Bottomline

Try not to get carried away with the wide array of ETFs at our disposal. While they may be exchange-traded, it does not mean that all ETFs are meant for day-trading. Some ETFs are meant to be day-traded and held for a short period, and some are meant to be held for the next 3-5 decades.

The market exists to serve us, the investors, and not the other way round. 

As always, take personal responsibility of your financial well-being and do your own due diligence.

 

 

Check out my recent articles:

 

 


Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.

5 replies »

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s