How To Choose Exchange Traded Funds

Okay.  So you’ve decided you want to save for retirement. And you don’t want to be limited to cash in the bank.  You want to get into stocks, bonds, realty, commodities.  But you’ve read that you need to own at least twenty stocks to be diversified, and that’s before you even add bonds, realty and commodities.  So you have to buy like forty, fifty, or more individual assets?

Help!

Help is on the way.  What you’re looking for is funds.  Funds are basically just collections of individuals assets all gathered together into one that you can buy, sell and hold just like one.

Exchange Traded Funds (ETFs) are a type of fund that is, well, traded on an exchange, just like stocks.  To you, this means you can buy and sell them in your brokerage account.  But within each fund there can be scores of stocks, bonds, commodities or properties.  Even hundreds or thousands.  This allows you to build a complete diversified portfolio with only a handful of positions to manage.  Depending on how much fine tuning you may want to do, as little as three positions can allow you to be diversified globally and by asset class.

I’ve discussed the three most useful to American investors before:  IAU, GOVT & VT.  Let’s suppose though that you’ve invested in these three funds, but now that you have some experience under your belt, you’re more of a hands on type that wants to tweak and fine tune things.  What do you look for?

The first place to start is by looking at track records.  You want to look at fund rankings and choose the funds that have performed the best over the past year, five years, or ten years.  Then buy them.  Right?

No.

In case that wasn’t clear, NO!!!  One standard prerequisite for investing in a fund is to read the prospectus.  It’s a good idea, really.  But you may soon discover that they’re not really that helpful in selecting a fund.  These are documents written by lawyers, for lawyers.  Their main purpose is to disclose costs and risks.  There’s little in the way of context, however, in which to put them in perspective.

There is one disclaimer though, that is found in all of them:  PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.  Truer words were never spoken.  It’s not even close.  Usually past performance isn’t even the barest hint of future results.

So if you can’t go by track record, then what else is there?

Glad you asked.  Remember we started out by listing the main asset classes to invest in?  That’s our first hint.  We want to our fund selections to cover these bases.  With one exception: you may already own a big chunk of realty, if you own your own home.  What’s more, many stock funds include real estate stocks.  This is why we could say you could cover the bases with as little as three funds; one for stocks, one for bonds, one for commodities.

But here we’re assuming you want to have a little more control than just buying a fund for each asset class.  If you were to own only one stock fund, for example, the logical choice is one that owns them all.  VT is as close as it gets.

But suppose you want to buy a few stock funds.  Easy; just pick a few top performers.  No, we put that to rest before.  So at this point you want to put together a few funds that give you broad coverage of the stock universe, but may be more selective.  Say a US stock fund and an ex-US stock fund.  Maybe you’re an investor that prefers dividend income,in which case you could choose one of each.  Or a “growth” investor or a “value” investor.  Or better yet, someone who still wants to cover the field, but also wants control over how much of each.

There are a number of good places to start.  Morningstar, Lipper, and a number of newer fund data aggregators can be searched for the criteria you want to emphasize.  Look at expense ratios.  A fund expense ratio of just, say, 0.30% annually may seem insignificant, but if the dividend yield on the underlying stocks is 1.50%, that 0.30% is taking 20% of your dividend income.  You’re left with just 1.20%.  So do mind the expenses.

But since you’re looking to do some fine tuning here, the first thing to ask yourself is what role do so want this fund to play?  If it’s a stock fund, and you’re looking for a value orientation, look at the criteria the fund uses to select and weigh stocks.  Is it what you’re looking for?  If it’s a bond fund, what kind of bonds does it track?  Short term, medium term, long term?  Treasuries, corporate bonds, municipalities?  US?  Non-US?  State?  High quality or high yield?  (Good luck finding both!).  If it’s a commodity fund, is it gold, silver, oil, agriculture?  Single or multiple commodity?

Also bear in mind that asset class allocation is one of the strongest determinants of risk and return.  And to the extent you’re investing by asset class, the more broadly you diversify within each asset class, the better your results will reflect your allocation.  So if your stock ETFs are narrowly targeted, you may be adding sources of risk you hadn’t counted on. Unless there is a specific compelling reason to do so, I avoid highly specialized funds and prefer stock funds that have a large number of holdings.  Ideally I want to own the whole market, but weighted more by certain factors than market capitalization.

A final exercise is to review the fund’s holdings.  This for me is the most important criterion.  Do these things look like things you want to own?  Because if you buy the fund, they are the kind of things you will own.

The best place to find this detailed information about a fund is usually the fund issuer’s web site.  Below are three links for the funds listed above.  You can find similar information for virtually any ETF available to you.  I would never invest in a fund without carefully reviewing this information.  In any case, this is how I settled on the ETFs I cited in My Favorite ETFs.

https://advisors.vanguard.com/investments/products/vt/vanguard-total-world-stock-etf

https://www.ishares.com/us/products/239468/ishares-us-treasury-bond-etf

https://www.ishares.com/us/products/239561/ishares-gold-trust-fund

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