Be critical in this ETF love affair
By: Sin Ting So
Tags: Index, Investing, Etf, Fees, Mutu

“Know what you own, and know why you own it.” - Peter Lynch

Everything about the other person is perfect in the first few weeks of dating. Short of kicking puppies, there is pretty much nothing your new person can do wrong. Even habits that you already know will annoy you one day are temporarily adorable. But just like a new relationship, most investors don’t care about the details of what they invest in and don’t try to find out more. Although ETFs aren’t exactly new to the market, growth in the industry has been astronomical over the last few years. As everyone fawns over ETFs and jumps on the bandwagon, it’s important to take the love goggles off and make sure you know what you’re buying.

The first ETF was launched in 1993. In 2009, assets topped $1 trillion; this year they hit $4 trillion. This has been on the whole a boon for investors, who have benefitted from the lower cost of ETFs and performance of passive investing (which we know almost always outperforms over the long-run) versus active funds. We love low cost investing, but there are some things to look out for when making decisions around ETFs.

Tracking error. ETFs, for the most part, are passive instruments that track the returns of a benchmark index rather than trying to beat the market. Many investors are surprised to learn that some ETFs do not exactly track the indices they were created to mimic. The higher the tracking error from its benchmark, the less the ETF can be used to represent it. The ETF issuer can try to reduce tracking error, but this can potentially add expenses, which are typically passed on as a higher management fee to investors. You can’t assume that two ETFs that track the same benchmark will perform identically or cost the same amount.

Synthetics. Sometimes, an ETF is just a wrapper. You need to dig deeper to see what the ETF is actually invested in. For example, United States Oil Fund (USO) is one of the more popular commodity ETFs. What investors don’t realize is that the ETF invests only in oil futures, and doesn’t directly track the performance of oil’s spot price. Always understand the underlying products you are holding through an ETF.

Cost. Similar ETFs from different providers, or even the same provider, have highly variable expense ratios (the cost of the ETF, which is taken out of the ETF price every day). Take for example Blackrock’s emerging market ETFs IEMG (iShares Core MSCI EM ETF) and EEM (iShares MSCI EM ETF): their expense ratios are 0.14% and 0.72% respectively. That is a huge spread for very similar exposure. There are also other costs involved in executing an ETF portfolio strategy such as brokerage fees and bid-ask spreads when trading. Another lesser-known fact: Sometimes ETF issuers generate income by lending out their underlying securities to hedge funds to enable short sales. This does result in lower management fees, but also increases the risk to you.

Mythbusting: ETFs are always cheaper than mutual funds (unit trusts) is false. There are mutual fund providers such as Vanguard and Dimensional Fund Advisors that have management fees in-line with or below ETFs for similar and even better implemented exposure.

Drink the koolaid, but take the goggles off.