×

Evaluating investors' favorite asset: 3 tips for looking under the ETF hood

  • Nearly $3 trillion of assets under management flowed into ETFs in 2016.
  • Familiarize yourself with the index your ETF is based upon and then decide whether you want the help of a financial advisor.
  • Consider the fund's underlying holdings.

Many analysts are predicting that exchange-traded funds will continue to sweep up assets in 2017. ETFs recorded $288.6 billion of inflows in 2016 and closed the year with nearly $3 trillion in assets under management.

Traded on exchanges just like stocks, these index-tracking investments have attracted investors with their trading flexibility, low costs and tax efficiency. Yet how well do investors actually understand the funds they're buying?

As with any investment, advisors and individual investors should be ready to undertake careful due diligence before buying an ETF. One common source of confusion when it comes to these funds is that there are often sizable discrepancies between ETFs whose naming conventions sound very similar yet utilize very different approaches in terms of how they actually invest.

ETFs are traded on exchanges, so they can be bought and sold like stocks through a brokerage.
Tetra Images | Getty Images
ETFs are traded on exchanges, so they can be bought and sold like stocks through a brokerage.

For example, ETFs with "low volatility" or "minimum volatility" in their names can turn out to behave quite differently for investors in precisely the environment that they are most looking for risk mitigation. Likewise, some sector-focused ETFs may offer similar exposures, even though their names are different — infrastructure versus construction, for instance.

A fund's name might seem like a good starting point for gaining an initial understanding of how it is constructed – "Infrastructure," for example, would seem to have something to do with the facilities, roads and power supplies needed to operate society. Unfortunately, names turn out to offer little help for evaluating funds. There is simply no universally accepted system in use by ETF providers and research to classify funds. S&P has its Global Industry Classification Standard, Morningstar has a Global Equity Classification Structure and these systems are as subtly different from each other as their own names.

More from Portfolio Perspective:
Why asset allocation is so important for investors
What makes an advisor trustworthy?
Buying stock? Ask yourself this question first

Since discrepancies will continue to exist in how ETFs are named and categorized, investors need to understand the underlying index methodology of the funds they are considering. Methodology signals how an ETF is likely to perform in different market conditions, and it also dictates how securities are selected and weighted, and the timing and frequency with which the portfolio is rebalanced.

Understanding the methodology of a fund's underlying index requires knowledge of whether it employs a constrained or unconstrained approach and how that might impact the performance of the portfolio.

An unconstrained approach to volatility, for example, utilizes a transparent, rankings-based methodology that evaluates each stock's realized volatility within a given universe over a specified period and selects stocks that have exhibited lower amounts of volatility.

The term "unconstrained" comes from the fact that the strategy is not constrained by sector or geography. While an unconstrained low-volatility index may have sector or industry overweights when volatility strikes, it can reallocate away from volatility during scheduled re-balancing.

Your Wealth: Weekly advice on managing your money

Sign up to get Your Wealth

Please enter a valid email address
Get this delivered to your inbox, and more info about about our products and service. Privacy Policy.

Another common approach to low volatility is minimum variance (also known as minimum volatility) portfolio construction, which requires portfolio constraints to avoid significant concentration in specific sectors and individual stocks. Minimum variance portfolios optimize an index using an estimated co-variance matrix. This is intended to produce an index with the lowest absolute volatility for a given set of constraints, which results in an allocation similar to market benchmarks from a sector perspective, which some investors may view as a benefit.

That said, however, it is important to keep in mind that these constraints may make it difficult for the portfolio to steer away from volatility — particularly when it is centered in a given sector (think technology at about 30 percent of the index during the deflation of the tech bubble or financials during the global financial crisis).

Lastly, to supplement information gleaned from an ETF's sector classification, it's helpful to look at the individual holdings of its underlying index. What companies comprise that sector allocation? What are their primary lines of business, and how do they provide exposure to the desired sector? What is the short- and long-term outlook of each sector?

"Ultimately, the proper implementation of ETFs in a portfolio requires, like all investment decisions, due diligence, caution and persistence."

Here are some key steps all investors should take when evaluating ETFs:

  1. First, decide if you are going to be a do-it-yourself investor or work with an advisor. As their name suggests, ETFs are traded on exchanges, so they can be bought and sold like stocks through a brokerage.
  2. Whether or not you use an advisor, make sure you understand the index underlying the ETF you are considering. Focus on how the index is constructed, what it tracks and how long it has been around — a longer record will reveal how the index responded to different market conditions.
  3. Also ask about the fund's underlying holdings, as well as any tax considerations. An advisor won't necessarily have all the answers to your question, but he/she should have resources available to give you some guidance.

Ultimately, the proper implementation of ETFs in a portfolio requires, like all investment decisions, due diligence, caution and persistence. ETFs can offer many attractive features, but their long-term value depends on how well they fit into any individual portfolio. To evaluate appropriate fit, investors have to be prepared to look under the hood.

— By John Feyerer, director of equity ETF product strategy at PowerShares by Invesco

Latest Special Reports

  • A globe-trotting look at the world of investing, from developed Europe and Asia trends to the least-traveled frontier markets.

  • Unlock the keys to building a successful long-term financial plan: manage your money, grow your money, and protect it.

  • Watch investments

    Covering the full set of tools and strategies for long-term investors: How to take everyday market fluctuations in stride, and when to know it’s time to take action or protect against a major economic shifts.

Investing

Financial Advisors