Exchange traded funds have grown substantially in popularity over the past 10 years. By the end of 2018, there were 1,988 different offerings totaling $3.4 trillion in value in the U.S. alone. That represents a 330% increase in assets allocated to those investments and a 150% jump in the number of different ETF choices.
There are now nearly four times as many exchange traded funds as there are individual stocks in the S&P 500. Choice is good, but too much choice can be paralyzing, so the first step in building an ETF portfolio is to weed out all the distractions.
Exchange traded funds are similar to more familiar mutual funds but differ in their creation and distribution. Mutual fund shares are created and redeemed by the fund company at the end of each day in response to purchase and sale requests. ETFs trade actively throughout the day on the major stock exchanges. The first exchange traded fund was authorized by the SEC in 1993 and tracked the value of the S&P 500 index. In fact, until 2008, issuance of the funds was limited to passive tracking of major stock and bond indexes and more than 80% of ETFs today are still tied to an index (although only loosely in some cases).
In 2008, the SEC granted authorization for fund sponsors to create “actively managed” exchange funds that opened the door to a multitude of specialized or targeted offerings that do not track an index but invest in a particular strategy or commodity (cannabis funds are all the rage this year). What was originally intended as a simplified investment path for passive investors grew into the Wild West. If you can dream it up, someone has already launched an ETF tied to it.
Choosing appropriate options can be a daunting task, particularly given the explosion in advertising hype and the unfortunate proliferation of a short-term “trading” mentality. Here are a few factors to consider.
› Simplicity. The point of fund investing is to obtain broad, diversified exposure. That means mostly sticking to funds that follow the major indices in broad asset classes (U.S. Equity, International Equity, Emerging Markets, Fixed Income, and so forth). You may also have a preference for a sector like energy or health care. There are numerous index ETFs that track the 11 broad S&P sectors. Avoid ETFs whose name is undecipherable (the “Innovator S&P 500 Power Buffer ETF” invests in “customizable Flexible Exchange Options” and seeks to match returns of the S&P 500. The SPDR S&P index ETF also seeks to match the index by simply buying the index, at 90% less cost. Hmm.)
› Cost. The first thing to look at as you evaluate a fund is the cost of ownership, or “expense ratio.” Especially when indexing, selecting a low-cost ETF is critical, as additional fees sap performance over time. Competitive pressure has driven fees and expenses relentlessly lower, and today some brokerage firms offer their own broad index ETFs with expense ratios as low as 0.03% and no trading commissions.
› Liquidity. Some ETFs, especially some of the oddballs, have low “liquidity;” that is, not much money invested in the fund, low trading volume, and light volume in the underlying stocks. For example, the “Obesity ETF” (ticker “SLIM”) has only $10 million in assets and only trades 1,500 shares per day. Good one to cut from the menu.
In general, ETFs have given many investors a cost-effective path to building a well-diversified long-term retirement portfolio. The key is to tune out the noise, stick to basics, and ignore the strange and obscure mutants that come and inevitably disappear each year.
Christopher A. Hopkins, CFA
Vice President and Portfolio Manager
Barnett & Company