A beautiful thing is happening inthe ETF industry: Fund companies and platform providers are competing on productdifferentiation. Sure, you could argue that this has been happening for thelast few years, but the market is competing on an entirely new level today.Yesteryear’s first-mover advantage is being challenged by lower-pricedofferings and enhancements to existing structures. From an investor’sperspective, this makes me want to jump for joy. I’m getting better productselection, better pricing, and ultimately better market execution as a result. Providers,please, keep it coming!
Systemizing Your InvestmentDecisions
I am oftenasked whether I think there are too many ETFs on themarket. Frankly, no I do not, but let me qualify that statement. Takethe ETF market in the
The key is to have aninvestment idea before you go searching for a fund, not the other way around.If you start subjecting yourself to the attributes of the fund’s strategybefore you even know what you are looking for, you run the risk of beingbrainwashed. In other words, you won’t be the buyer of an ETF; someone willsell it to you. There’s a distinction between the two, and that problemwouldn’t exist if we could whittle the global product universe down to a fewhundred funds. The glut of options forces many investors to be specific abouttheir goals before they even begin shopping; with fewer options, investorsmight not prepare so scrupulously. Therefore, the benefits of fund proliferationcan far outweigh the inconveniences.
In order to keepyourself from getting stuck with a poor fund in your portfolio, your decisionprocess should focus on these four issues, listed in order of importance:
- Asset allocation (by far the most important)
- Strategy (active versus passive, style, etc.)
- Transaction costs
- Product class (mutual fund or ETF)
Youmight think it would have a greater relevance relative to the other factors.The fact of the matter is that you should gain the exposure you seek throughthe cheapest means possible, regardless of whether it is an ETF, mutual fund,or even a gold coin. Just be sure to measure all the costs, not just the statedannual expense ratio.
Total Cost Analysis
So, what makes one fund the bestchoice for one investor and another similarly structured product better for thenext investor? It boils down to the total cost of ownership. The explicitcosts—payments you will know even before you make the trade—include the expenseratio and the transaction cost from your broker. For a trade of $10,000, a $10transaction cost on a security held for one year will be 0.1%. Add that to,say, a 0.25% annual fee on a large-cap domestic equity ETF, and you’re alreadyat 0.35% in fees.
Now you need to consider the liquidityof the ETF to assess the implicit costs. Any ETF trade will incur that peskybid-ask spread, which will become more meaningful with the larger trades,simply because the very act of investing large sums of money causes the spreadto widen a bit. We call this the market impact, which is a statistic wecalculate on all ETFs with a long-enough track record, and we employ it whendeciding which ETFs we deem to be the most liquid.
You’ll also need to consider otherfactors, such as the rebalancing costs of the methodology—a market-cap approachis going to be cheaper than an equal-weight approach with quarterly resets.Finally, you’ll want to think about tracking error and how much money the firmwill send back your way from things like share lending.
Is it complicated? Yes. Does itdiffer based on your investment size? You bet. One size does not fit all inthis case, but that seems to be a recurring theme in investing.
