Three Questions to Ask Before You Buy an ETF

 
A decade ago, exchange-traded funds (ETFs) were barely on investors' radars.
 
But since then, the ETF industry has exploded. ETFs are now the bread-and-butter tool for everyday investors looking for an easy way to invest in a particular geographic region, market, sector… you name it.
 
A record $3.4 trillion of assets under management (AUM) is now held in ETFs. That's a nearly 17-fold increase since 2003.
 
And this trend isn't slowing down anytime soon…
 
What's behind all this new money in ETFs?
 
Investors have been disappointed with the relatively high fees and underperformance of active funds (that is, funds where managers select stocks themselves). This has made ETFs – low-cost, passive funds that simply track a particular benchmark index – more attractive.
 
ETFs have radically democratized the investment process for everyday investors. But like everything in investing, you need to make sure you know what you're buying.
 
Here are three things you should consider before you buy an ETF…
 
   1. What is the cost?
 
ETFs charge a fixed-percentage annual running cost to shareholders. This is known as the "expense ratio." While an actively managed fund might charge, say, 1% of AUM and a percentage of profits, ETF expense ratios are typically less than 0.50%. And expense ratios continue to decline.
 
However, you still need to know what's expensive and what's not…
 
Remember, different underlying ETF assets will affect the expense ratio. If the ETF tracks a major benchmark developed market index like the S&P 500, the expense ratio should be low.
 
But if it holds a wide range of emerging market stocks, expect the ratio to be higher. It's more expensive for an asset manager to replicate a basket of stocks across multiple exchanges – so the expense ratio will reflect those costs.
 
When I want to establish a baseline for a particular type of ETF, I check fund manager Vanguard's ETF page. Vanguard is renowned for offering the most cost-effective ETFs. It currently offers 55 ETFs across a range of underlying asset classes and sectors. So when I'm comparing costs, I use Vanguard as a starting point.
 
   2. How is the liquidity?
 
Liquidity is the ease with which you can buy and sell a security in the market without affecting its underlying price.
 
When it comes to most individual investors, our buy and sell orders don't visibly move the market. But they can if we're looking at things like thinly traded small-cap stocks. And some ETFs can suffer from a lack of liquidity, too…
 
The first sign that an ETF might not be easy to trade in and out of comes from looking at its AUM. A small ETF is far likelier to suffer from low liquidity than a large multibillion-dollar fund.
 
The second factor to consider is the nature of the underlying securities in the ETF. If your ETF holds a basket of large-cap developed market stocks, then liquidity won't be a problem.
 
On the other hand, look at an ETF like the iShares Barclays USD Asia High Yield Bond Index ETF (AHYG on the Singapore Exchange). With $75 million in total assets, it's small… And it holds relatively illiquid assets (Asian high-yield bonds). In cases like these, liquidity is going to be a problem.
 
If you choose to buy a relatively illiquid ETF, please make sure you use a limit order. That means when you place your buy or sell order, specify the maximum purchase price (or minimum selling price) you are willing to accept.
 
   3. How does the index work?
 
I can't stress this enough – when you are buying an ETF, you're not only investing in a basket of securities, but ALSO in the mechanics of how the underlying index works.
 
In the early days of ETF investing, this was less of a consideration. Most of the first ETFs sought to replicate standard benchmark indexes, like the S&P 500. But today, the number of indexes has exploded to around 5,000 globally… And they cover every imaginable type of investment.
 
Beyond all of these different sectors and themes, you can also find a growing list of "smart beta" indexes.
 
Most indexes simply take a basket of stocks and weigh them according to their respective market caps. But smart beta indexes use more complicated factors to choose their underlying stocks… They can account for volatility and risk, or track stocks with the most momentum, or seek out dividend payers. By doing this, smart beta indexes aim to provide investors with enhanced returns.
 
Smart beta indexes – and the ETFs that track them – might sound appealing. But you need to take the time to read through the index-construction documents. You can't just take the name of an ETF at face value and assume it's giving you what it says it is… Always "read the fine print" of your investments.
 
So if you're looking to invest in an ETF, make sure you do your homework. Read the fine print, and make sure you know exactly what you're getting into by answering these three questions first.
 
Good investing,
 
Tama Churchouse
 
Editor's note: Tama is on the hunt for investment opportunities around the world that aren't on the radar of most investors and aren't talked about in the mainstream media. Learn more about The Churchouse Letter – including a once-in-a-generation opportunity that you can invest in right now – right here.

Source: DailyWealth

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