By: David Sterman of Street Authority
The rapid proliferation of the exchange-traded fund (ETF) industry has been a boon for investors.
Many folks now simply focus on a key sector or trend, and buy the most suitable ETF to hit their target. For these folks, the time and energy of individual stock research just isn't worth it. Yet the process of picking the right ETF can be downright confusing.
Let's say you want to own an ETF that focuses on industrial companies. Do you choose the SPDR Industrial Select Sector ETF (NYSE: XLI), the Vanguard Industrials Index ETF (NYSE: VIS) or the iShares Dow Jones U.S. Industrial Sector Index ETF (NYSE: IYJ)? Before you answer that question, know that there are also more than a dozen other industrial ETFs, with a niche focus on China, multinationals, small caps... the list goes on.
Frankly, we may have reached a point of too many ETFs, and some funds will simply wither away from a lack of interest. According to XTF.com, investors can now choose from more than 1,600 ETFs that collectively control more than $150 billion in assets. In just the month of June, 24 new ETFs were launched. It's getting hard to keep score.
Many new ETFs are falling under the category of "smart beta," which I discussed a few months ago. These funds tend to be pricier than traditional passive ETFs, which have less portfolio turnover and, typically, much lower expense ratios.
To help you choose the best ETFs, it helps to assess the companies behind these funds, known in the industry as ETF sponsors. Many of them pursue distinct strategies, and may or may not dovetail with your investing style. First, you should know about the big three: BlackRock's (NYSE: BLK) iShares program, State Street's (NYSE: STT) SPDRs funds, and the Vanguard funds.
All of these firms aim for big market niches and can often gather $1 billion or more in assets under management (AUM) for each fund they sponsor. That helps them to establish rock-bottom expense ratios, and their high trading volumes tend to lead to small bid/ask spreads. As a result, many investors use these funds as short-term tactical trading vehicles. Their transaction costs are so low that they can be bought and sold with frequency -- if you have a strong sense that a certain investment theme will play out in the next few months.
Look for more action on the low-cost front: Fidelity and Charles Schwab (NYSE: SCHW) are making a big push into low-cost ETFs as well.
The overwhelming size of these ETF behemoths means that smaller rivals must scramble for niches that are not covered by others. Take WisdomTree as an example. That firm offers a wide range of funds, but may be best known for its dividend and earnings growth-focused funds, which target China, small caps and many other regions and asset classes. According to ETFdb.com, WisdomTree's funds have an average expense ratio of 0.50%, which makes their funds best-suited for investors that have a longer time horizon with their investments.
I am especially intrigued by the ETF industry's smaller players. Their funds aren't always a great choice as they can carry high expense ratios and often struggle to gather a large base of assets to manage. But such funds exploit creative investing themes, and can deliver solid returns. For example, the PowerShares Buyback Achievers ETF (NYSE: PKW) and the AdvisorShares TrimTabs Float Shrink ETF (NYSE: TTFS) were quick to spot the share buyback phenomenon and capitalized on their popularity while the big ETF players were caught napping. The fact that such funds have done well offsets the pain of relatively high expense ratios.
Moving further downstream is one of my favorite fund firms: Global X.
This firm has committed its energy to developing many country-specific ETFs, from Scandinavia to Africa to the Far East, greatly enhancing access to these markets and regions for U.S. investors. One of my favorite ETFs -- in theory -- is the Global X FTSE Andean 40 ETF (NYSE: AND), which focuses on the dynamic economic growth in the Western flank of South America. I say "in theory" because this fund has less than $10 million in AUM and very low trading volumes. It's simply too small to recommend. Instead, investors may as well focus on a bigger regional fund such as iShares MSCI Chile Capped (ECH), which has more than $300 million in AUM.
I'm also keeping an eye on a new fund firm, KraneShares, which has launched three new China-focused funds over the past year. For example, its KraneShares CSI China Internet ETF (Nasdaq: KWEB), which focuses on Chinese growth stocks, is up an impressive 35% since launching last August. According to its fund marketing materials, the company works with an index provider that builds and rebalances the portfolio. The index aims to weed out the riffraff of dubious Chinese companies that have made that country a no-go destination for U.S. investors.
Risks to Consider: Any ETFs that fail to develop a meaningful base of AUM after a few years is at risk of being closed. And simply liquidating stakes in a portfolio can cause downward pressure on the underlying price of those holdings that are being sold.
Action to Take -- The best approach to ETFs: Become familiar with 30 or 40 funds that meet your criteria in various investing climates -- and forget about the other 1,600. That way, you can selectively move in and out of those funds you know well as valuation, growth rates or macroeconomic issues change from year to year.
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