Exchange-traded funds are no longerjust market-cap-weighted index funds. Many of them are distinct strategies inand of themselves or represent highly active bets on exotic asset classes. Inother words, they require careful consideration before investing. Here’s how aMorningstar ETF analyst looks at the choices available to investors.
1. Understand the Asset Class and Strategy
Assessing an ETF is largely about examiningits underlying asset class or strategy. It requires investors to think like aportfolio manager and come up with a view—not necessarily a short-term one—onan asset’s qualities, such as its expected returns and volatility. We look athistorical behavior and academic theories for clues as to how an asset classmay behave in the future. What do the asset’s long-run returns and volatilitylook like? What measures predict its long-run returns? What conditions coincidewith good or bad performance? How does the asset create value? In many cases,this requires breaking down an asset class to its risk factors.
Stocks are a bet on moderateinflation and economic growth; foreign bonds are bets on sovereign creditquality, inflation, interest rates, and currency appreciation; and so forth.Seemingly distinct asset classes—like stocks and high-yield bonds—can haveoverlapping risk exposures, and thus behave similarly.
Judging a strategy requires adifferent tack. We’re only comfortable investing in strategies that have beendemonstrated to work across many different markets and long periods of time,thoroughly tested by numerous researchers. Ten years of back-testing isn’tanywhere near close enough. The strategy also needs a rigorous, intuitivetheory on why it works. It seems like some products out today are based onlittle more than witchcraft.
We also like simple and transparentimplementations. When a strategy becomes overly complicated, we becomeconcerned about data-fitting, the possibility that someone tested numerousmodels until something stuck to the wall, and operational shortfalls. Of thecountless strategies out there, the most rigorously tested and theoreticallysound include momentum and value.
2. Consider How the ETF Will Affect the Portfolio
An ETF—in fact, anyinvestment—shouldn’t be viewed in isolation. All that truly matters is how itwill affect a portfolio’s overall behavior. A low-return, high-risk fund can bea great addition to a portfolio if its returns are uncorrelated to other assetsor if its positive returns come during nasty times, like bear markets.Seemingly disparate asset classes can be connected to the same factor. Forexample, Brazilian stocks, Canadian stocks, and commodities are all tightlycoupled to
3. Tote Up All the Costs, Explicit and Implicit
Expense ratios can sometimes be amodest portion of a fund’s total costs. Some very popular indexes, such as theS&P 500 and the Russell 2000, suffer price-impact costs.
When hundreds of billions ofdollars buy or sell the same stock at the same time, the stock can becomemisvalued. New York University Professor Antti Petajisto estimates thatinvestors have lost about 0.3% and 0.8% annualized in the S&P 500 and theRussell 2000, respectively, because of coordinated index-fund trading. Othersources of drag include bid-ask spreads of the ETF and trading fees incurredduring rebalancing.
ETFs that deal with relativelyilliquid securities like micro-caps and high-yield loans can also sufferprice-impact costs. Read the fine print! Leveraged ETFs often have hiddenborrowing costs.
Knowing the basics of analyzingETFs, how can investors use ETFs effectively in their portfolios? One key isnot to abuse the investor friendly features of ETF.
Beware the Accidental Portfolio Manager
A hidden migration is under wayamong money managers, a countless legion entering the rarified ranks of hedgefunds, pension funds, and mutual funds. Many of these newly minted portfoliomanagers have little formal training and don’t have the monomaniacal devotionto analyzing the markets that the best portfolio managers have. Who are thesebrave souls? Why, none other than do-it-yourselfers who actively attempt totime, trade, and pray their way to superior risk-adjusted returns, often withthe help of exchange-traded funds.
ETFs can be used effectively toachieve a good long-term result, but investors who trade too often and ventureinto asset classes they know little about, or obtained insufficient researchon, are setting themselves up for disappointment. The frequent traders are notcapitalizing on the low costs or tax-efficient traits of ETFs. In fact, theyare likely getting a worse result than most actively managed mutual funds couldprovide, and they are almost certainly going to underperform a more passivestrategy over time.
Don’t get into bad behavior
The criticism of ETFs that we hearmost frequently from mutual fund boosters is that ETF investing leads to badbehavior. But just because ETFs trade intraday does not mean that investorsshould make it a daily or even weekly habit. ETFs should be used in nearly thesame way a mutual fund is used. ETFs have not revolutionized investingconcepts; they are merely changing the way in which investors can gain accessto asset classes.
Investors who actively time theirETF trades to exploit valuation or technical views don’t realize how tough itis to consistently generate excess returns. Investors who have thought aboutthe skill hurdle involved may reason that because the top third of mutual fundsbeat their benchmarks over five years, all they have to do is be in the topthird skillwise relative to mutual fund managers to generate excess returns (nomean feat!). However, much like poker, with just a few trials it’s hard to tellwhether an investor is good or just plain lucky. In fact, the markets are evenmore luck-driven than poker, so even fairly long performance records don’t giveinvestors a foolproof litmus test of skill.
Stay alert to Illusory Superiority
Despite the high skill hurdleinvestors must surpass to be confident of generating alpha, many ETF investorsstill choose to run a high-turnover, often-expensive investment strategy. Theproblem is behavioral. People tend to overestimate their positive qualities, thinkingthey’re smarter, better-looking, and more skilled than they really are, aphenomenon called illusory superiority. This cognitive bias traps mostinvestors in an epistemological pit, where their self-assessments don’t reflectreality. One way to avoid falling prey to illusory superiority is to anchorskill assessments to an objective measure, such as outperformance against thebenchmark. But because the market is extremely noisy, it’s impractical for mostinvestors to obtain a statistically significant measure of their own skill.Even if the measured period is long enough, choosing the right benchmark—ascience unto itself—compounds the difficulties of the typical investor.
The statistically high skill hurdlefor active management to pay off and the cognitive biases that trap mostinvestors suggest that investors should take a margin-of-safety approach toactive management. This means keeping costs down as much as possible and beingextremely picky about exotic investments that venture beyond low-cost,well-diversified funds with fundamental cash flows.
Investors should treat the marketwith respect—it’s something not easily conquerable—and acknowledge the sheeramount of luck that determines investment results. To do otherwise isfoolhardy.
Samuel Lee is an ETFanalyst with Morningstar. This article originally appeared in MorningstarAdvisor Magazine. This is an edited version by Editorial and Research Team,Morningstar Asia.
