We examine differentiators that help distinguish between two comparable ETFs.
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By Esther Pak | 04-12-11 | 06:00 AM | Email Article

Question: I'm lost in a sea of iShares and SPDRs. They all offer exchange-traded fund products that seem very similar--both in name and the indexes they track. How do I pick one over the other?

Esther Pak is an assistant site editor of Morningstar.com.

Answer: Investors should be careful to note that two ETFs that invest in the same asset class can behave very differently because of differences in the underlying attributes of each. In fact, investing in ETFs entails more comparison shopping than an investor might expect. Below, we've listed some key differentiators that an investor should keep in mind when comparing two similar ETFs dedicated to the same market segment.

Expense Ratio
The expense ratio is the most reliable predictor of future performance for mutual funds, and ETFs are no exception--that is, cheap funds, on average, tend to be better performers than those that are more costly. And in many respects, ETFs and index funds are commodities; there's little differentiation, so you might as well go with the cheapest one. For example,  iShares MSCI Emerging Markets Index  and  Vanguard MSCI Emerging Markets ETF  are two very similar ETFs that track the same index. But the expense ratio is the most significant differentiator between them--the iShares ETF has a price tag of 0.69% compared with 0.22% for the Vanguard ETF. While these two ETFs feature other differences, the large discrepancy in price leads our analysts to favor Vanguard's offering. The "Fees and Expenses" tab for individual ETFs on Morningstar.com provides an overview of a fund's expense ratio as well as the average for its peer group.

In addition, our  ETF Analyst Reports include commentary on ETFs' expenses and whether they are cheap or dear in relation to comparable ETFs and open-end mutual funds.

Index Construction and Underlying Holdings
Depending on the index that an ETF tracks, two ETFs that focus on the same sector and have similar names can have radically different underlying holdings. Taking a look under the hood of each ETF enables you to see how the fund weights its holdings and how diversified (or undiversified) a fund is.

For example,  SPDR Dow Jones International Real Estate  holds 111 stocks with 40.14% of its assets concentrated in its top 10 holdings while Vanguard Global ex-US Real Estate ETF  holds 399 with just 26.49% in its top 10 holdings. A glance at each ETF's list of underlying holdings yields further differences. While many of their holdings overlap, Dow Jones' top holding is Westfield Group, whereas the top holding for Vanguard's offering is Sun Hung Kai Properties.

Check out our individual ETF Analyst Reports for a detailed discussion on portfolio construction, including our analysts' take on how the ETF might fit into an asset-allocation framework as well as the risks it could potentially introduce.

Commissions to Buy and Sell
As you compare and contrast various ETFs, also pay attention to what it will cost you to buy and sell an ETF. These charges will vary depending on your brokerage firm, with several firms now offering commission-free trades on a specific list of ETFs. If you're a buy-and-hold investor who plans to invest a large sum and let it ride, these commissions shouldn't make a big difference to you. But if you trade frequently, you should focus on funds/platforms where you'll enjoy free trading.

Also shop around for free trades if you employ a dollar-cost averaging approach. Investors who invest small sums of money regularly over a long period of time could quickly rack up broker fees that eat into their returns.

Bid-Ask Spread
In addition to paying attention to commission rates, ETF investors should also mind bid-ask spreads. Such spreads aren't an issue for traditional index mutual funds; the price you pay is whatever price the fund closed at on the day before. But ETFs, like stocks, trade intraday on exchanges, and buyers and sellers have to agree on the price. Checking the bid-ask spread data points, you'll see the highest price that a buyer is willing to pay for an ETF, the lowest price for which a seller is willing to sell it, and the difference between the two. The larger the spread, the higher your costs will be to execute the trade.

The size of the spread gives you a sense of the liquidity of an ETF and its underlying holdings. ETFs with a lot of trading volume that also hold highly liquid securities will have very small bid-ask spreads. For example, the bid-ask spread of  SPDR S&P 500  was recently 0.01%. Less-liquid ETFs, meanwhile, can exhibit much higher bid-ask spreads--for example,  PowerShares DB Japan Government Bond  recently had a bid-ask spread of 1%.

The spread can either widen or tighten depending on trading volume, but investors will usually be exposed to some spread even with the most liquid ETFs.

With that said, investors should rest assured that most ETFs have pretty slender bid-ask spreads. Morningstar ETF analyst Sam Lee recommends that with the exception of the most liquid ETFs, investors should always use limit orders to help ensure that they obtain an advantageous price.

Premium/Discount
In addition to bid-ask spreads, ETF investors also need to keep an eye on whether the fund is trading at a premium or discount to its net asset value. An ETF's net asset value is calculated by dividing the total value of the portfolio's securities by the numbers of its shares outstanding. On the other hand, the market price of an ETF--the price at which you actually buy and sell your shares--is determined by the forces of supply and demand, just as is the case for stocks. As a result, the market price of an ETF can deviate from its NAV. When the market price is higher than its NAV, the ETF is trading at a premium; that means you are paying more for an ETF than its holdings are actually worth. When an ETF's market price is lower than the NAV, it is trading at a discount, and you're buying the ETF for less than the value of its holdings.

Like the bid-ask spread, premium/discounts are affected by the liquidity of the ETF's underlying holdings and trading volume.

ETFs that traffic in highly liquid securities, such as U.S. stocks or government bonds, tend to exhibit only small discounts and premiums. But the premium/discount numbers become more relevant in the realm of international, non-Treasury bond, and commodity ETFs. These asset classes might trade at premiums or discounts because of supply/demand imbalances or other factors. This doesn't mean you should avoid these ETFs, as they might provide worthwhile diversification benefits. Moreover, premiums and discounts often self-correct, so what appears to be a high premium today might not be there tomorrow.

Rather than focusing on absolute discounts and premiums, investors should focus on the movement of the discount or premium from the day that they buy the ETF, which ultimately determines whether your investment was profitable.

For more information, read Christine Benz's article on what premiums and discounts mean for ETFs.

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Esther Pak does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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Morningstar - 2011/04/12 - How to Home In on the Best ETFs - <a href="http://www.morningstar.com/articles/author/1571-esther-pak.aspx">Esther Pak</a>
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