Five Ways to Find a Winning ETF
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Sukumar.N
Nov 26, 2008, 5:09:03 AM11/26/08
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Five Ways to Find a Winning ETF
Exchange-traded funds (ETFs) have come a long way since the launch of
the first U.S. fund in 1993, the Standard & Poor's Depositary
Receipts, better known as spiders. This ETF tracks the S&P 500, and
its popularity with investors led to the introduction of ETFs based on
other benchmark U.S. equity indexes such as the Dow Jones Industrial
Average and the Nasdaq 100. From their early beginnings as equity-
index trackers, ETFs have grown to encompass a huge array of
investment choices - but they aren't all equal in quality. In fact,
the flip side to the phenomenal growth in ETFs is that it increases
the risk that some of them will be liquidated, primarily due to lack
of investor interest. How can you find a profitabale ETF to fit your
portoflio? Read on to find out.
Wide Selection of ETFs
=================
The wide array of choices in ETFs includes ETFs based on U.S. and
international equity indexes and subindexes, bonds, commodities and
futures as well as ETFs based on investing style (value, growth or a
combination) and market capitalization. According to a 2008 report by
State Street Global Advisors, as of June 2008, there were as many as
698 ETFs listed on U.S. exchanges with combined assets of $575
billion.
Competition Among ETFs
===================
The ETF market has become an intensely competitive environment. In a
bid to differentiate themselves from the competition, some ETF issuers
have developed products that are either very specific in focus or are
based on an investment trend that may be short lived.
An example of a niche ETF is the HealthShares Autoimmune-Inflammation
ETF. This esoteric ETF tracks an index of U.S. and foreign publicly
traded companies that are involved in the clinical research and
development of treatments for autoimmune/inflammatory diseases such as
arthritis, multiple sclerosis and psoriasis.
As for ETFs that are based on hot investment trends, consider the
growing number of ETFs based on alternative energy sources such as
wind or solar power. While much of the alternative energy sector
enjoyed a huge run-up as crude-oil prices approached the $150 per
barrel level in July 2008, it is debatable whether investor appetite
for the sector will be as voracious when oil prices are less robust.
Picking the Right ETF
================
Given the bewildering number of ETF choices that investors now have to
contend with, it would be appropriate to consider the following
factors when selecting an ETF:
1. Level of Assets: To be considered a viable investment choice, an
ETF should have a minimum level of assets, a common threshold being at
least $10 million. An ETF with assets below this threshold is likely
to have a limited degree of investor interest. As with a stock,
limited investor interest translates into poor liquidity and wide
spreads.
2. Trading Activity: An investor needs to check if the ETF that is
being considered trades in sufficient volume on a daily basis. Trading
volume in the most popular ETFs runs into millions of shares daily; on
the other hand, some ETFs barely trade at all. Trading volume is an
excellent indicator of liquidity, regardless of the asset class.
Generally speaking, the higher the trading volume for an ETF, the more
liquid it is likely to be and the tighter the bid-ask spread. These
are especially important considerations when it is time to exit the
ETF.
3. Underlying Index or Asset: Consider the underlying index or asset
class on which the ETF is based. From the point of view of
diversification, it may be preferable to invest in an ETF that is
based on a broad, widely followed index, rather than an obscure index
that has a narrow industry or geographic focus.
4. Tracking Error: While most ETFs track their underlying indexes
closely, some do not track them as closely as they should. All else
being equal, an ETF with minimal tracking error is preferable to one
with a greater degree of error.
5. Market Position: "First-mover advantage" is important in the ETF
world, because the first ETF issuer for a particular sector has a
decent probability of garnering the lion's share of assets before
others jump on the bandwagon. It is therefore prudent to avoid ETFs
that are mere imitations of an original idea because they may not
differentiate themselves from their rivals and attract investors'
assets.
ETF Liquidations
=============
The closing or liquidation of an ETF is usually an orderly process.
The ETF issuer will notify investors in advance - generally three to
four weeks - about the date when the ETF will stop trading. That said,
an investor with a position in an ETF that is being liquidated still
has to decide on the best course of action in order to protect his or
her investment. Essentially, the investor has to make one of the
following choices:
1. Sell the ETF shares before the “stop trading” date: This is a
proactive approach that may be suitable in cases where the investor
believes that there is a significant risk of a substantial near-term
decline in the ETF. In such cases, the investor may be willing to
overlook the wide bid-ask spreads that are likely to be prevalent for
the ETF due to its limited liquidity.
2. Hold on to the ETF shares until liquidation: This alternative may
be suitable if the ETF is invested in a sector that is not volatile
and the downside risk is minimal. The investor may have to wait a
couple of weeks for the issuer to complete the process of selling the
securities held within the ETF and distributing the net proceeds after
expenses. Holding on for the liquidated value eliminates the issue of
the bid-ask spread.
Regardless of the course of action, the investor will have to contend
with the issue of taxes arising from the liquidation of the ETF
investment. For example, if the ETF was held in a taxable account, the
investor will be responsible for paying taxes on any capital gains.
Conclusion
========
When selecting an ETF, investors should consider factors such as its
level of assets, trading volume and underlying index. In the event
that an ETF is to be liquidated, an investor has to decide whether to
sell the ETF shares before it stops trading or wait until the
liquidation process is completed with due consideration given to the
tax aspects of the ETF sale.
N.Sukumar
Research Analyst
www.kences1.blogspot.com
Exchange-traded funds (ETFs) have come a long way since the launch of
the first U.S. fund in 1993, the Standard & Poor's Depositary
Receipts, better known as spiders. This ETF tracks the S&P 500, and
its popularity with investors led to the introduction of ETFs based on
other benchmark U.S. equity indexes such as the Dow Jones Industrial
Average and the Nasdaq 100. From their early beginnings as equity-
index trackers, ETFs have grown to encompass a huge array of
investment choices - but they aren't all equal in quality. In fact,
the flip side to the phenomenal growth in ETFs is that it increases
the risk that some of them will be liquidated, primarily due to lack
of investor interest. How can you find a profitabale ETF to fit your
portoflio? Read on to find out.
Wide Selection of ETFs
=================
The wide array of choices in ETFs includes ETFs based on U.S. and
international equity indexes and subindexes, bonds, commodities and
futures as well as ETFs based on investing style (value, growth or a
combination) and market capitalization. According to a 2008 report by
State Street Global Advisors, as of June 2008, there were as many as
698 ETFs listed on U.S. exchanges with combined assets of $575
billion.
Competition Among ETFs
===================
The ETF market has become an intensely competitive environment. In a
bid to differentiate themselves from the competition, some ETF issuers
have developed products that are either very specific in focus or are
based on an investment trend that may be short lived.
An example of a niche ETF is the HealthShares Autoimmune-Inflammation
ETF. This esoteric ETF tracks an index of U.S. and foreign publicly
traded companies that are involved in the clinical research and
development of treatments for autoimmune/inflammatory diseases such as
arthritis, multiple sclerosis and psoriasis.
As for ETFs that are based on hot investment trends, consider the
growing number of ETFs based on alternative energy sources such as
wind or solar power. While much of the alternative energy sector
enjoyed a huge run-up as crude-oil prices approached the $150 per
barrel level in July 2008, it is debatable whether investor appetite
for the sector will be as voracious when oil prices are less robust.
Picking the Right ETF
================
Given the bewildering number of ETF choices that investors now have to
contend with, it would be appropriate to consider the following
factors when selecting an ETF:
1. Level of Assets: To be considered a viable investment choice, an
ETF should have a minimum level of assets, a common threshold being at
least $10 million. An ETF with assets below this threshold is likely
to have a limited degree of investor interest. As with a stock,
limited investor interest translates into poor liquidity and wide
spreads.
2. Trading Activity: An investor needs to check if the ETF that is
being considered trades in sufficient volume on a daily basis. Trading
volume in the most popular ETFs runs into millions of shares daily; on
the other hand, some ETFs barely trade at all. Trading volume is an
excellent indicator of liquidity, regardless of the asset class.
Generally speaking, the higher the trading volume for an ETF, the more
liquid it is likely to be and the tighter the bid-ask spread. These
are especially important considerations when it is time to exit the
ETF.
3. Underlying Index or Asset: Consider the underlying index or asset
class on which the ETF is based. From the point of view of
diversification, it may be preferable to invest in an ETF that is
based on a broad, widely followed index, rather than an obscure index
that has a narrow industry or geographic focus.
4. Tracking Error: While most ETFs track their underlying indexes
closely, some do not track them as closely as they should. All else
being equal, an ETF with minimal tracking error is preferable to one
with a greater degree of error.
5. Market Position: "First-mover advantage" is important in the ETF
world, because the first ETF issuer for a particular sector has a
decent probability of garnering the lion's share of assets before
others jump on the bandwagon. It is therefore prudent to avoid ETFs
that are mere imitations of an original idea because they may not
differentiate themselves from their rivals and attract investors'
assets.
ETF Liquidations
=============
The closing or liquidation of an ETF is usually an orderly process.
The ETF issuer will notify investors in advance - generally three to
four weeks - about the date when the ETF will stop trading. That said,
an investor with a position in an ETF that is being liquidated still
has to decide on the best course of action in order to protect his or
her investment. Essentially, the investor has to make one of the
following choices:
1. Sell the ETF shares before the “stop trading” date: This is a
proactive approach that may be suitable in cases where the investor
believes that there is a significant risk of a substantial near-term
decline in the ETF. In such cases, the investor may be willing to
overlook the wide bid-ask spreads that are likely to be prevalent for
the ETF due to its limited liquidity.
2. Hold on to the ETF shares until liquidation: This alternative may
be suitable if the ETF is invested in a sector that is not volatile
and the downside risk is minimal. The investor may have to wait a
couple of weeks for the issuer to complete the process of selling the
securities held within the ETF and distributing the net proceeds after
expenses. Holding on for the liquidated value eliminates the issue of
the bid-ask spread.
Regardless of the course of action, the investor will have to contend
with the issue of taxes arising from the liquidation of the ETF
investment. For example, if the ETF was held in a taxable account, the
investor will be responsible for paying taxes on any capital gains.
Conclusion
========
When selecting an ETF, investors should consider factors such as its
level of assets, trading volume and underlying index. In the event
that an ETF is to be liquidated, an investor has to decide whether to
sell the ETF shares before it stops trading or wait until the
liquidation process is completed with due consideration given to the
tax aspects of the ETF sale.
N.Sukumar
Research Analyst
www.kences1.blogspot.com
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