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By Jason Stipp | 10-18-2011 11:22 AM

Burns: The Steps to Picking a Good ETF

Before you select a good ETF, select a good investment idea, says Morningstar's Scott Burns.

Jason Stipp: I'm Jason Stipp for Morningstar.

As part of Morningstar's 5 Days to Better Investing, we're checking in today with our director of ETF, closed-end fund, and alternatives research Scott Burns to learn a little bit more about the fundamentals of good ETF investing.

Thanks for joining me, Scott.

Scott Burns: Jason, thanks for having me.

Stipp: So you mentioned to me recently that investors will come to you and they'll say, "Scott, I need to buy an ETF. What kind of ETF should I buy?" And you tell me this is absolutely the wrong question to start with. What's the problem there?

Burns: So you know the problem, they say, "I am looking for an ETF," and I always want to say to them, "Shouldn't you be looking for an idea first and then we'll go look for the ETF."

I think maybe some of that is semantics, but I do think unfortunately that a lot of people are just looking for that. "I am looking for stock; I am looking for an ETF." But that's not the way institutional investors invest, that's not the way money managers whether they are doing asset allocation with ETFs or even buying individual stocks, do things.

They think about an investment idea. They look for an opportunity, and then they check to see what kind of products are out there and see if there's mismatches in pricing, and what's the right product to match that investment idea. So, I guess, it's a little bit of the cart before the horse that's out there. So I always tell people, the first step to picking a good ETF is picking a good idea.

Stipp: Let's say you have the idea, whatever it might be. There are some reasons that you might look at ETFs and then there are some reasons that you might look at other types of investments, depending on what your needs are and what your idea might happen to be. What are some of those times when you would want to check out ETFs and see what they have to offer? And what are some times when ETFs might not get where you want to go?

Burns: You know, I mean ETFs definitely fit in role in the portfolio. I own ETFs and stocks and active mutual funds. I think if you're looking for ETFs on a strategic standpoint, you've really adopted a passive investing philosophy if you're going to use those at your core.

If you looking for ETFs to be more sophisticated tools, that is to pair them with maybe some other active mutual funds or some other individual holdings that are out there. ETFs are sliced and diced, a lot of people critic that, but that's actually one of the nice things is that you can get some ... pinpoint precision, whether it's portfolio completion or risk management or liquidity.

Then you have ETFs on the tactical side, where you're making tactical active investing, even active trading-type bets. If you're going to select an ETF there, I mean where I think it makes the most sense is where you think you're going to have broad price divergence across a category and not so much just one-off names that are off.

One of the other reasons I think you pick ETFs over, say, individual stocks is your investment thesis is only going to be at a very macro level and not be able to get down into the piece parts.

At the same time, there are a lot of ETFs that have a lot of significant weightings in single holdings. If you think of some of the broad energy ETFs that are 45% Exxon and Chevron. If that's your thesis, you may be better off just buying Exxon and Chevron, and saving yourself the management fee, basically, on the fund.

So it's always important to know what you own, and there are those trade-offs. If you want to buy an ETF and you expect it to beat the index, that's where you're going to want active management.

So those are definitely I would say the laundry list.

Stipp: So for strategic investors, historically, there have been concerns that you might rack up transaction costs in buying ETF, but some of those aren't really as big of an issue anymore issue on certain platforms. So it could be that you don't have to worry as much about those transaction costs with ETFs for the long-term investor.

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