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Know-How: How to Analyze an ETF

There's more to know than simply the underlying index.

Samuel Lee, 08/30/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

Exchange-traded funds are no longer just market-cap-weighted index funds. Many of them are distinct strategies in and of themselves or represent highly active bets on exotic asset classes. In other words, they require careful consideration before investing. Here's how a Morningstar ETF analyst looks at the nearly 1,300 choices available to investors.

1. Understand the Asset Class and Strategy
Assessing an ETF is largely about examining its underlying asset class or strategy. It requires investors to think like a portfolio manager and come up with a view--not necessarily a short-term one--on an asset's qualities, such as its expected returns and volatility. We look at historical behavior and academic theories for clues as to how an asset class may behave in the future. What do the asset's long-run returns and volatility look like? What measures predict its long-run returns? What conditions coincide with 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 moderate inflation and economic growth; foreign bonds are bets on sovereign credit quality, inflation, interest rates, and currency appreciation; and so forth. Seemingly distinct asset classes--like stocks and high-yield bonds--can have overlapping risk exposures, and thus behave similarly.

Judging a strategy requires a different tack. We're only comfortable investing in strategies that have been demonstrated to work across many different markets and long periods of time, thoroughly tested by numerous researchers. Ten years of back-testing isn't anywhere near close enough. The strategy also needs a rigorous, intuitive theory on why it works. It seems like some products out today are based on little more than witchcraft. We also like simple and transparent implementations. When a strategy becomes overly complicated, we become concerned about data-fitting, the possibility that someone tested numerous models until something stuck to the wall, and operational shortfalls. Of the countless strategies out there, the most rigorously tested and theoretically sound include momentum and value. 

2. Consider How the ETF Will Affect the Portfolio
An ETF--in fact, any investment--shouldn't be viewed in isolation. All that truly matters is how it will affect a portfolio's overall behavior. A low-return, high-risk fund can be a great addition to a portfolio if its returns are uncorrelated to other assets or if its positive returns come during nasty times, like bear markets. Seemingly disparate asset classes can be connected to the same factor. For example, Brazilian stocks, Canadian stocks, and commodities are all tightly coupled to China's infrastructure boom.

3. Tote Up All the Costs, Explicit and Implicit
Expense ratios can sometimes be a modest portion of a fund's total costs. Some very popular indexes, such as the S&P 500 and the Russell 2000, suffer price-impact costs. When hundreds of billions of dollars buy or sell the same stock at the same time, the stock can become misvalued. New York University Professor Antti Petajisto estimates that investors have lost about 0.3% and 0.8% annualized in the S&P 500 and the Russell 2000, respectively, because of coordinated index-fund trading. Other sources of drag include bid-ask spreads of the ETF and trading fees incurred during rebalancing. ETFs that deal with relatively illiquid securities like micro-caps and high-yield loans can also suffer price-impact costs. Read the fine print! Leveraged ETFs often have hidden borrowing costs.

Last but not least, consider taxes. Different structures can have wildly different tax treatments. ETFs (even those tracking the same index) can have different embedded taxable gains, though capital gains distributions are rare for most plain-vanilla ETFs. Funds that employ cash creation and redemption, have high turnover, or have virtually uninterrupted inflows are at greater risk of distributing capital gains.

Samuel Lee is an ETF analyst with Morningstar.

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